Back-to-normal supply chain fuels disinflation tailwind

REAL ECONOMY BLOG | January 25, 2023

Authored by RSM US LLP

Supply chains in the United States continued to recover in December, remaining at the pre-COVID level for the sixth straight month as most of the damage from the pandemic has now faded, according to the RSM US Supply Chain Index.

The recovery in supply chains has been one of the most important factors driving inflation down in recent months, especially goods inflation.

We expect this trend to continue. Our forecasts for December’s personal consumption expenditures index—a closely watched measure of inflation—point to a 4.9% year-over-year increase when it is released on Friday, down significantly from 5.5% previously.

We estimate that supply-chain disruptions contributed to about a third of the surge in inflation that occurred from 2020 to most of last year, in addition to demand-related factors like fiscal and monetary supports.

As both supply-chain disruptions and government spending wane, the U.S. economy is likely entering a period of rapid disinflation, which should bring the top-line PCE inflation from its peak at 7% year-over-year to the 3% to 4% range in the next six months.

The improvement of the supply-chain system was most evident when looking at how quickly goods inflation—which strongly correlates with supply efficiency—has decelerated.

The takeaway

In hindsight, this is the scenario that the Federal Reserve had expected in 2021 when inflation first spiked. The Fed had projected that inflation would ease once supply chains improved, but instead prices continued to surge because of shocks like the war in Ukraine and prolonged lockdowns in China.

To be sure, the rapid fall in goods inflation and inflation in general was also driven by the slowdown in overall demand, engineered by the Fed to tame inflation from the demand side.

Now, with both supply and demand working in the Fed’s favor against inflation, it is proper for the Fed to begin to slow down its rate hikes, starting with a likely 25 basis-point increase on Feb. 1.

Still, while goods disinflation will help push overall inflation down, we believe that inflation will stay sticky in the 3% to 4% range in the next phase of the inflation story.