How The Dynamic of Supply Chains and Inventories Could Create a Quick Drop in Inflation This Year

Here's a theory about inflation that you may not have heard. I could be wrong but this theory is based on a lot anecdotal evidence that seems to correlate with broad sets of data.

I've heard clients in Asia, Europe and the US complain about supply chain issues. Recently one told me about an item that used to have a lead time of 4 days that was recently quoted as having a lead time of 56 weeks.

For most of these clients, the price of any one item is of little consequence. They would pay double or quadruple for certain items that might mean the difference between being able to make their product or not. On site at one client making chips for cars years ago, I saw a sign reporting that the average new car has more than 100 chips. You only need a dozen of those chips to get stuck in a supply chain somewhere to delay production of the entire car. If paying more for a chip allows you to make the car, you will pay a lot more for that chip.

The other thing going on is that these folks are hoarding. If the supplies are available, they buy them. If delivery times have gone from 4 days to 4 or 40 weeks, they buy what they can now. And they don't care that much about the cost. The inventory is insurance against future supply chain issues.

To me, it sounds like the old beer game simulation that teachers of systems dynamics would run. In that, a one-time surge in demand in a system with lags could result in wild swings in demand and supply. I suspect something similar has happened here.

In the wake of the disruptions that hit with COVID, businesses are now buying more than ever. That is putting even more strain on supply chains that are working hard to produce more. Inventories are growing faster than sales. What could happen in this dynamic? Orders drop off as dramatically as they surged. People with excess inventory will halt orders.

What happens then? Prices drop.

Smarter people than me (folks like Paul Krugman and Larry Summers and Jason Furman) are arguing that inflation will take more than a year to drop. They're arguing for interest rate hikes to lower demand and thus slow inflation. They could well be right but I would trust them more if they even addressed what I see going on with clients.

ASML is one of the most complex companies you've never heard of. They make it possible to make the increasingly tiny chips that go into thousands of devices. They have a network of 4,000 suppliers. They are an extreme example of what I see everywhere.

25 years ago when I was first working with product development teams, about 10 to 20% of their work was outsourced, done by subcontractors and suppliers. That has doubled and tripled with most of my clients in the last 5+ years. Within the last year or two, I've had two clients who outsource about 90% of their development work. Discussing a subcontractor with one of them, I learned that the subcontractor actually had a subcontractor who was creating the item we were discussing. It's a world of supply chains and given the complexity of products it doesn't take much to disrupt them. Again, to protect against these disruptions they buy more to have inventory on hand, creating a surge in demand that could be a big part of what is driving up prices. To the extent that these various suppliers are ramping up production to meet these increase in demand for companies who are buying 100 for current production AND another 100 to create a bigger inventory to protect themselves against future disruptions, there could be a big drop in demand once companies feel safe enough to stop building up inventory. They might drop off on orders from 200 to 100 or - even worse - drop to ordering 0 and merely working down their inventory. In the first case, inflation would fall a little. In the second, inflation could drop a lot.

Lots of experts predicted there would be small gains in inflation from about 2% to 3 or 4% in this last year. Instead inflation hit 7%. Now experts are predicting persistent inflation in the range of 4.5% to 8% for another year or so. They might be right. They're the experts. But given the weird dynamic I hear in the stories from clients, I wouldn't be surprised to see inflation rates drop as dramatically as they rose in the last year as supply chains catch up or even overrun demand.