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Transcript

Tim Sablik: My guest today is John O'Trakoun, a senior policy economist at the Richmond Fed. John, welcome back to the show.

John O'Trakoun: Hey Tim, it's great to be back as always.

Sablik: Today, we're going to be looking at supply shocks stemming from the conflict in the Middle East. Shipping traffic through the Persian Gulf has been significantly constrained since the conflict began in late February through the time of this recording on June 15, although there was an announcement yesterday about an agreement to end the conflict and reopen the Strait of Hormuz.

During the preceding months, much of the focus has been on the disruption to crude oil shipments and the downstream effect that has had on fuel prices. But oil isn't the only commodity that travels through this waterway. John, what are some other key supply chains that have been disrupted these past months?

O'Trakoun: Beyond crude oil, we've seen disruptions to natural gas, fertilizers like urea, container and bulk shipping, and petrochemicals like naphtha, ethylene and propylene, which are the building blocks for making plastic and other types of synthetic rubbers. We've also seen disruptions to helium, which is a key input to semiconductor manufacturing. Almost a third of the global supply of helium comes from Qatar. Aluminum has also been affected, with the Middle East accounting for about 9 percent of the global supply. That could flow through to auto manufacturing and aircraft manufacturing.

Sablik: What measures do we have for tracking supply chain stress?

O'Trakoun: There are a number of measures that are related to supply chains. One thing you could look at, for example, is the cost of shipping. We have several measures like the Baltic Dry Index. That measures the cost of shipping raw bulk commodities like iron ore, coal, and grain by sea. Or, we can look at the Drewry East-West Airfreight Price Index, which measures air freight costs. You could look at the number of port calls or the volume of imports and exports handled by global ports, for which the IMF publishes daily data. And, you can get important signals about supply chain conditions from surveys of global manufacturing businesses. These surveys are used to calculate Purchasing Managers' Indexes, or PMIs, which are a measure of how business activity has grown or shrank from month to month. Often, these surveys will ask questions about inventories, costs, and supplier delivery times. All of these are highly related to supply chain stress.

Some people have tried to bottle up all these various indicators into a single summary statistic — that's a real tongue twister [laughs]. Examples include the World Bank's Global Supply Chain Stress Index or the Global Supply Chain Pressure Index published by the New York Fed. Those can serve as a broad measure of how supply chains are doing.

Sablik: Aside from this current episode, we've experienced a series of supply shocks in the last six years such as the COVID-19 pandemic shutdown and reopening, the Russian invasion of Ukraine, and changes to tariffs. How do measures of supply chain stress now compare to some of these recent past episodes?

O'Trakoun: If we focus on the World Bank and the New York Fed indexes I mentioned earlier, both of them are showing that global supply chain stress is elevated compared to the historical average. The World Bank's index is getting close to the heights that we saw during the pandemic recovery. The New York Fed's index shows that supply chain stress is more than one and three-quarters standard deviations above the historical average. That is a level you'd rarely see if supply chain stress was randomly distributed.

Sablik: Do we have any sense of how businesses are navigating the current supply shocks?

O'Trakoun: Businesses have several ways of cushioning themselves from the impact of supply shocks. They can protect themselves from materials shortages by maintaining inventories of the goods they need to make their products. They can also protect themselves from cost shocks through fixed price contracts with their suppliers or through financial strategies like hedging.

However, these measures can only last for so long. Inventories can run low and eventually have to be replenished. And, when the new fiscal year rolls around, contracts and hedges might expire and have to be rewritten, potentially at higher prices.

Of course, some businesses are navigating the shock by passing on costs to consumers, raising prices or implementing surcharges. Not every business is equally able to do this. It depends on how much pushback they're getting from their customers. We're hearing that B2B companies, which are businesses that sell to other businesses, are having more luck with passing on costs compared to B2C companies that sell directly to consumers.

Sablik: On that note, are there any indications that businesses are close to exhausting mitigation measures like drawing down inventories or the other things you mentioned?

O'Trakoun: I'm not sure that they're fully exhausted, but we're definitely seeing signs of these measures being used up. Inventories are falling relative to sales at the manufacturer level, the wholesale level, and the retail level. When you look at inflation-adjusted inventory levels, we're seeing them run low for some commodities like primary metals for manufacturing. For wholesalers, the real inventories of metals and minerals, and of miscellaneous durable goods are running really low. So, it's something to keep an eye on.

Sablik: With the run of supply shocks that we've experienced in the past six years, are there any signs that businesses are becoming more adept at responding to them, more resilient to supply stress?

O'Trakoun: In the PMI surveys I mentioned earlier, businesses are asked about whether their customer inventories are running low. In the pandemic supply shock, we saw a surge in this indicator. So far, we haven't seen the same degree of increase in the current supply shock. Maybe that's partly attributable to businesses becoming a little more adept at managing supply conditions. But, as I said earlier, these things could worsen as the supply shock continues.

Probably the biggest indicator of how adept businesses are at managing this is their bottom line. In the recent quarterly earnings season, corporate earnings were really, really healthy. Net income margins for the S&P 500 were up to an all-time high. Even excluding the technology sector, which has been doing amazing, profitability was up. The median S&P 500 company saw earnings grow by almost 13 percent year over year. That's a really robust pace of growth.

Sablik: We've recently had some indications that the Strait of Hormuz may soon reopen, as I mentioned at the beginning. But, as we experienced after COVID, supply chains can take some time to return to normal after a big disruption. Do we have any information from businesses about their expectations for how long the effects of this shock might last?

O'Trakoun: For the most part, our business contacts expect that reopening the Strait will be a gradual process. They think it'll take months for supply conditions to return to normal after a deal is signed. Energy infrastructure that was damaged during the conflict will take time to rebuild and restart. Ships and shipping containers are in the wrong locations and need to be relocated. And, it'll take time to clear the Strait of mines that were set during the conflict. Despite the latest news about the peace agreement, it could be a while before companies develop confidence about how sustainable the peace is and how secure their operations in the Gulf will be.

Sablik: So, that's covering how businesses are responding. How are consumers reacting to this supply shock? I mentioned oil at the beginning, and I think higher gas prices have been the most immediately visible change in consumer prices from the conflict. So, how are households responding to those higher gas prices?

O'Trakoun: We do see households cutting back on the amount of gas they're buying as a result of these high prices. In the latest PCE spending report from April, real consumption of gasoline and other energy goods was down almost 2 percent year over year.

But I think the most surprising thing so far has been how resilient the U.S. consumer has been despite the shock. They're still spending on discretionary categories. For example, real spending on recreation services was up almost 4 percent year over year. Real spending on recreational goods and vehicles was up three and a half percent year over year. And, in May, light vehicle sales came in above a 16 million unit seasonally adjusted annual rate, which is basically in the same range it's been for about three years. Big-ticket items like autos would be among the first things consumers pull back on when they're feeling nervous about the future, so this could be a positive sign about the state of consumer finances.

On the other hand, it's important to remember that this energy shock came at the same time as tax refund season was going on. That could be one reason we're seeing spending look so resilient. Now that those payments have all gone out, the coming months' spending figures might show more weakness.

Sablik: How do these supply disruptions factor into the Fed's policy discussions?

O'Trakoun: Supply shocks are challenging for monetary policy because they're associated with higher prices and slower economic growth at the same time. That puts pressure on both sides of the Fed's mandate.

Another challenge is that these negative supply shocks stemming from the conflict are not happening in a vacuum. The U.S. could also be undergoing a positive supply shock that comes from AI, which you'd expect to eventually expand our economy's productive capacity and bring inflation down.

Fed policymakers are going to have to carefully assess the inflation and labor market data, as they always do, to make sure the stance of policy is well positioned in this two-sided risk environment.

Sablik: John, thanks so much for joining me today!