MP3 created a self-reinforcing demand explosion that is getting harder, not easier, for supply to keep up with.
Even as supply disruptions and higher inflation persist, markets are discounting that they will soon subside, leaving inflation at central bank targets and allowing for very easy monetary policy for a very long time. We disagree. While the headlines tend to focus on the micro elements of the supply shock (the LA port, coal in China, natural gas in Europe, semiconductors globally, truckers in the UK, etc.), this perspective largely misses the macro cause that is likely to persist and for which there is no idiosyncratic solution. This is not, by and large, a pandemic-related supply problem: as we’ll show, supply of almost everything is at all-time highs. Rather, this is mostly an MP3-driven upward demand shock. And while some drivers of higher inflation have been transitory, we see the underlying demand/supply imbalance getting worse, not better.
The mechanics of combined monetary and fiscal stimulus are inherently inflationary: MP3 creates demand without creating any supply. The MP3 response we saw in response to the pandemic more than made up for the incomes lost to widespread shutdowns without making up for the supply that those incomes had been producing. This is very different than post-financial-crisis MP2, where QE, by and large, was not paired with significant fiscal stimulus but instead offset a credit contraction and, as a result, was not inflationary.
We’re now seeing the inflationary mechanics of MP3 play out and observing just how potent a tool it is. And while the composition of the demand it fueled will evolve (e.g., shift from goods back toward services as COVID recedes), demand is likely to remain highly elevated. There are still large stockpiles of latent spending due to the transformative effects that MP3 has had on balance sheets and the ongoing incentive provided by extremely low real yields, and more fiscal stimulus is on the way. Choking off demand would require central banks globally to move toward restrictive policies quickly, which looks unlikely.
In this research, we paint a picture of the surge in demand and how supply is straining to meet it virtually everywhere you look. There are not enough raw materials, energy, productive capacity, inventories, housing, or workers. We start with this broad-brush picture because the demand-driven nature of the problem results in a game of whack-a-mole: alleviating a shortage in one area will likely just exacerbate the problem elsewhere in the supply chain.
Supply has recovered remarkably quickly. As you can see in the top chart, real goods production is now higher than it was pre-COVID. The issue is that demand has exploded, creating an imbalance of a magnitude that we haven’t seen since the 1970s. The bottom charts show the current imbalance in historical perspective. What happened in the ’70s truly was a supply shock: supply collapsed, and demand stayed relatively steady. Today, demand is surging, and supply is also growing, but it just can’t keep up with demand.
While some of the goods demand is unlikely to persist because of the unique circumstances of COVID prompting people to shift their spending from services to goods, the problem of shortages is also happening for services and is likely to build. The chart below shows that demand for services is rapidly returning to pre-COVID levels and services employment is lagging, as employers are having trouble finding workers.
As services demand continues to normalize, that will put more pressure on a labor market that is already very tight (as we’ll get into more below). As a rough size of the magnitude of the problem, if you take the typical relationship of how much labor it takes to satisfy services demand, a return to pre-COVID levels of services demand would push unemployment to historical lows. Addressing this imbalance will mean placing upward pressure on wages to entice more workers to work longer as well as requiring investment to improve productivity.
Given the cause of massive demand, addressing these shortages is like a game of whack-a-mole. You can fix it in one place, but you can’t fix it everywhere in any simple way. It’s going to require a lot of investment and/or a lot of productivity enhancement to catch up. But right now, the gap is so large—and policy remains so loose that it’s encouraging demand further—that this gap is likely to be reasonably sustained.
In terms of household demand, we’ve described in detail how Monetary Policy 3 created a lasting transformation. Governments transferred a massive amount of cash to households, more than offsetting lost income from COVID. Household balance sheets are now in a materially better state than they were pre-pandemic, as MP3 created a significant amount of wealth, pushing up the value of assets like equities, housing, cryptocurrencies, and so on. These gains have been broad-based across the economy, not just in the top decile or quantile. Ongoing stimulative financial conditions have further lowered debt service costs, and incomes have also benefited as economies have reopened. In short, households are wealthy, flush with cash, and ready to spend—setting the stage for a lasting, self-reinforcing surge in demand.
Below, we go granularly across the supply side, reviewing each set of shortages and price increases we’re seeing in the economy today. While each case has its own idiosyncratic drivers, in all of them, the level of demand is outpacing the level of supply, which is higher than pre-COVID levels. As a result, prices are rising and will likely continue to do so unless there is a significant boost in productivity so supply can catch up with demand, or policy makers shift to a tighter stance in order to reduce demand.
Metals prices have risen sharply since last year, as demand has far outstripped supply. Looking ahead, it will be hard to bring supply online because of the significant underinvestment in capex spending over the past decade, and capex spending itself will be a further strain on limited resources. In fact, capex remains muted even now that prices and demand for non-fuel commodities are back to or above pre-pandemic levels. Some commodities, most notably US shale, can ramp up quickly. But many can take up to 10 years to bring new capacity online, so shortages are likely to persist.
Looking at examples of individual markets triangulates the picture that the price increases are due to demand, not supply. For copper, aluminum, and nickel, supply is much higher than in recent years, but prices are still rising, and inventories are being driven down.
Similarly, there’s not enough energy to power economic activity given the current levels of demand. Prices of natural gas, coal, and oil are all spiking, all around the world. There are idiosyncratic constraints on supply, such as environmental regulations on coal in China or Russia restricting natural gas exports to Europe. But prices are rising across the board because demand is surging, and that demand is eating into inventories despite reasonable levels of production.
To keep up with the surge in demand, global production has risen above trend, as shown earlier. Most of the marginal productive capacity has come from China, which has ramped up its production significantly above pre-COVID trend, but there is a limit to how much it can stretch. Chinese production is 20% higher, and exports a full 40% higher, than at the start of 2020. (This is why there’s not enough coal in China—massive global demand has created a massive need for energy.)