The interconnectedness of global supply chains means that when one price goes up, others tend to follow. Increases in labour, energy and transport costs are contributing to inflation around the world, posing difficult policy challenges.
Back when we could travel easily, a regular announcement at airports all over the world was: ‘The airline would like to apologise for the delay to your flight. This is due to the late arrival of the incoming aircraft.’ But this essentially just says that we are late because we are late. Of course, it is true: lateness can create further lateness.
A similar phenomenon happens with prices. Prices increase because prices have increased; we experience inflation because there is inflation. While consumer price inflation has been relatively low and stable for the last 20 years, the last few months have seen a big jump in price growth alongside lots of discussions about the role of supply chain disruptions.
Increasing inflation in 2021
In December 2021, consumer prices, measured by the Consumer Prices Index (CPI), were 5.4% higher than a year previously in December 2020. This price increase (the annual rate of inflation) is up from 4.2% in the year to October 2021 and represents the highest rate since March 1992 (when it stood at 7.1%). Inflation has been increasing since last April when lockdown measures from earlier in 2021 were relaxed (see Figure 1).
Figure 1: UK consumer price inflation (as measured by the CPI)
Source: Office for National Statistics
The increase in inflation has been driven by the rising prices of goods. Service prices have also started to recover (or at least they had before the Omicron variant of the virus that causes Covid-19 induced further restrictions).
The pressure on goods prices reflects the dramatic change in our lifestyles since the start of the pandemic. Whether out of necessity to address our new living and working arrangements, or because many sectors had to shut down, demand quickly shifted from services (such as catering, accommodation and entertainment) to goods (such as food, beverages and consumer goods). This unexpected demand, combined with the effects of Covid-19 on production, severely affected the availability of such goods and, with it, their prices.
Because inflation is the rate of change of prices, typically measured compared to a year earlier, the substantial increase this year can partly be explained by the economic halt last year, which depressed overall consumption and prices. This ‘base effect’ reflects the fact that the reference price level from a year before was at its lowest, accentuating the increase this year.
What affects the price of goods and services?
But where do price increases come from? Producers generally set prices to maximise their own profit (exceptions to this objective include third sector firms). Of course, sometimes they make pricing decisions that do not make the most profit immediately but provide future benefits (like brand loyalty) or increase demand for other products. But ultimately, firms seek at the very least to cover the costs that they incur in production.
This raises the question as to whether recent price increases come from increases in the costs of inputs. Which input costs have gone up?
The main inputs, and therefore costs, vary by industry. But broadly speaking, most costs come from paying workers (labour), the goods and services needed for production (such as raw materials), the costs of use of machinery and technology, and logistics (storage and transport).
If the costs of any of these go up, there may be pressure on firms to raise their prices. If all of them go up, there will be greater pressure. When the inputs that are common to most firms go up, more sectors increase prices further, raising the costs for the sectors they supply. This is the supply chain of inflation.
How can labour costs affect prices?
Recently, firms in many sectors have faced difficulties recruiting. This drives up wages in those sectors, and workers have rightly sought wage increases to cover the rising cost of living. This has meant that average weekly earnings are rising across most sectors (including private, public, services, finance, manufacturing, construction and wholesale).
What about energy costs?
The recent increases in energy costs will not be a surprise to anyone. Figure 2 shows recent movements of oil and gas prices, which fell at the start of the pandemic, recovered in early 2021 but have surged since the summer of 2021. This partly reflects a hot summer (increased use of cooling technology) and higher seasonal demand from winter heating needs in the Northern hemisphere. Increased overall demand as economies recover is also an important factor.
Oil supply is constrained somewhat due to sanctions on Iran, while gas supply is affected by geopolitical factors related to Nord Stream 2, the controversial new pipeline due to bring Russian gas to Germany through the Baltic Sea. The situation in the UK is made worse by the depreciation of sterling against the US dollar (which makes oil, priced in dollars, more expensive), resulting in an additional burden for local producers.
The depreciation of sterling has happened as a result of many factors: the US economy has been recovering more strongly; interest rates in the United States rose faster than in the UK; and the UK has been afflicted by continuing uncertainty over its trading relationship with the European Union (EU).
Figure 2: Oil and gas prices
Supply chain links between companies also give rise to unusual implications of the energy price increases. The high energy costs were a cause of September’s shortages in the UK of some fizzy drinks, beer and meats. The link is that the carbon dioxide (CO2) used to carbonate drinks, and used for the slaughter of animals, comes as a by-product in the production of fertiliser. But production at the biggest fertiliser plants ceased because of the soaring costs of natural gas.
Even though these firms had contracted delivery of gas, it became more profitable for them to not use the gas in their own production and instead to sell it on at the high price to other companies. This meant no CO2generation – and shortages of certain products tends to push up their prices.
How about the costs of freight and distribution?
In the past year, there has been a steady increase in the container freight index, which approximates the cost of transporting goods via shipping liners. The index peaked at $10,839 last September, reaching a level that was almost ten times higher compared with two years before ($1,279). Other freight costs, such as air freight, have risen similarly.
These rising costs reflect many things. One driving force behind the rising cost of freight is the higher oil price. But there are also factors directly related to Covid-19.
For example, there is a knock-on effect of reduced airline capacity, especially into and out of Asia as a result of travel restrictions. Since planes are not travelling with paying passengers, the high-value goods that used to be transported by air must now be sent by sea. But this means that these goods compete for the capacity on cargo ships that was once used for lower-value goods. This re-evaluation of the priority of goods shipments means that the trade disruptions affect some goods more than others. Those lower-value goods that are shipped face higher costs.
There have been other Covid-19-related issues. For example, there have been delays unloading cargo when ports have been understaffed due to sickness or isolation. And the widespread shortage of heavy goods vehicle (HGV) drivers has meant that the port warehouses are left fuller for longer. This leads to ships waiting to enter port and unload goods, which increases shipping times (and hence costs). These higher costs are passed on to the shipping company’s customers.
Other shipping disruptions have been unlucky occurrences – for example, the disruption from the well-publicised grounding of the Ever Given ship in the Suez Canal in March 2021 as well as wider weather disruptions. But while in normal times a disruption would represent an unlikely and isolated event, all the events together have cumulated to produce bottlenecks in the system. With each additional setback, the world trade network has become more strained.
What effect do shortages and higher input prices have on inflation?
As in the case of CO2 shortages, the impact of supply disruptions can lead directly to price increases in the affected goods. But these shortages don’t have to be driven by other price increases.
For example, semi-conductor plants have been affected by Covid-19-related disruptions. Although already facing large back-order books, semi-conductor plants across Asia had to shut down at the start of the pandemic when their staff had to follow lockdown rules. This exacerbated the starting position and the costs of re-establishing the dust-free environment in which microchips are made meant that production was costly to bring back to full capacity. This has meant that many consumer goods – from mobile phones to cars – have had their production affected. These shortages can lead to consumers bidding up prices.
What is the overall effect?
The energy sector price increases are important because they affect virtually all sectors as a critical input. This matters because it means that not only do the costs of energy increase for a particular firm, but as their suppliers also face increases in energy costs, it feeds directly into their input costs too. Rising costs of distribution for internationally traded goods, including those goods that are part of the production process in domestically produced goods, has a similar effect.
Not all industries are affected equally. Goods with a long supply chain may end up with bigger input price effects because every step along the chain will compound the inflationary impact from both the raw input and the transformed good.
Take, for example, the market for processed meat: animals need to be fed and sheltered. Forage is itself a by-product of agriculture, which needs fuel and electricity to operate. The same holds for every step of the process of harvesting, transforming, storing and delivering the animal feed to the farm and then the animal to the slaughterhouse to wholesale retailers.
Compared with the rather simple market for diamonds, which is vertically integrated and requires low processing for the retail end-uses in jewellery and heavy construction, the market for processed meat is likely to have to absorb the impact of higher commodity prices more times before the final product reaches a supermarket shelf.
Figure 3 shows the close relationship between manufacturing input costs and prices charged. The relationship is not always one-for-one. In late 2016, manufacturing input costs rose strongly (in part due to the UK’s referendum vote earlier that year to leave the EU), but the price charged increased less quickly. In contrast, the rising input costs in virtually all sectors since the pandemic have led to greater upward pressure on output prices.
Figure 3: Manufacturing input cost growth and output price inflation
Source: Office for National Statistics
To what extent can firms pass on higher costs to their consumers?
So why would a firm not increase prices if they faced higher costs of inputs? The risk of losing customers usually makes producers reluctant to increase their prices, although if there is high demand, then firms can charge higher prices without fear of depressing sales.
The gap between the price charged to customers and the cost of producing a unit of the item sold – the mark-up – reflects the excess that goes to the producer as earnings to cover profits, other costs and new investments. This wedge means that producers can choose occasions when to absorb higher costs and avoid having to increase prices (which may result in a loss of consumers), and when to pass on the higher costs.
Before the pandemic, prices (and wages) were typically quite predictable and only increased by small amounts per year. Stable input prices, as well as competitive pressures, reduced the pricing power of firms, which were reluctant to increase prices too much.
But in the past year, firms have seen a resurgence of demand as economies re-opened. This demand has been supported by a build-up of cash balances, a pent-up desire for certain goods and experiences, and continued support from fiscal and monetary policy.
At the same time, a combination of factors has contributed to rising input prices. When rising input prices are matched by strong demand, firms gain pricing power – that is, they are able to charge higher prices without fear of putting off customers and depressing their sales. When firms know that competitors are also facing similar cost pressures, it is also easier to pass on the costs safe in the knowledge that it is likely that their rivals will do the same.
So higher prices can feed higher prices through the supply chain. The risk that central banks wish to avoid is a widespread belief taking hold that larger price increases are going to be the norm going forward. This would mean that even temporary cost increases will be passed on to customers and further feed the likelihood of inflation – a self-fulfilling prophecy.
But raising interest rates, which is the standard inflation-fighting tool of central banks, risks weakening a fragile economy that is still fraught with uncertainty. This is one of the difficult balancing acts that will dominate policy-makers’ decision-making in 2022.
Where can I find out more?
On inflationary pressures:
- Inflation: is now the time to get worried? by Chris Giles (Financial Times, 19 November 2021)
- Inflation ideology: camp permanent or camp temporary? by Maria Demertzis (Bruegel opinion piece, 9 December 2021)
- Shortage nation: why the UK is braced for a grim Christmas by Tim Harford (Financial Times, 14 October 2021)
- A perfect storm for container shipping (The Economist, 16 September 2021)
On the energy crisis:
- Gas shortages: what is driving Europe’s energy crisis? by David Sheppard (Financial Times, 11 October 2021)
- Don’t expect big oil to fix the energy crunch (The Economist, 16 October 2021)
On supply chains:
- The supply-chain mess by Daron Acemoglu (Project Syndicate, 2 December 2021)
- Bottlenecks: causes and macroeconomic implications by Daniel Rees and Phurichai Rungcharoenkitkul (Bank for International Settlements bulletin, 11 November 2021)
- The impact of lean inventories by Julio Ortiz (VoxEU, 17 December 2021)
Who are experts on this question?
- Jagjit Chadha, NIESR
- Richard Davies, Economics Observatory & University of Bristol
- Huw Dixon, Cardiff University
- Silvana Tenreyro, LSE and Bank of England
- Michael McMahon, University of Oxford