Higher interest rates could undermine supply chain resilience

Supply chain disruptions of the past several years—caused by a global pandemic and the Russia-Ukraine war, as well as ongoing US-China trade disputes—have largely been smoothed over.

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The Federal Reserve Bank of New York’s global supply chain pressure index, which accounts for transportation costs and manufacturing indicators, shows as much, with pressures returning to below pre-pandemic levels:

Yet supply chain risks still lurk. The Israel-Hamas war represents one immediate threat to global flows of trade and energy, particularly if the conflict spills over to become a more regional one. Extreme weather is another source of significant uncertainty; note how the El Niño drought is leaving the Panama Canal parched and crimping vessel traffic through a major chokepoint.

Then there are interest rates.

Economists have shown that elevated inflation levels since early 2021 can at least in part be blamed on supply chain snarls. As Matthew Gordon and Todd Clark of the Federal Reserve of Cleveland wrote in a paper last month, “Our estimates suggest that both aggregate demand and supply factors, including supply chain disruptions, have contributed significantly to high inflation.”

In turn, central banks worldwide, led by the US Federal Reserve, embarked on a long rate hiking campaign in an attempt to tame inflation. At 5.4%, the central bank’s benchmark rate is now at its highest level in 22 years.

Higher rates may crimp investment in diversification

Now, those higher interest rates may undermine companies’ efforts to make supply chains more diverse and resilient to shocks.

“Global supply chains largely normalized in 2023 after years of disruption, and the need for resilience is clear. The willingness of corporations to build that resiliency is not,” writes consultancy S&P Global in a new report on global supply chains published this week. “Falling operating margins and higher interest rates may be leading companies to cut their inventory balances and reverse recent supplier diversification increases.”

Diversification of a manufacturer’s supply base can help to mitigate inherent risks, but that effort brings with it additional upfront costs—and hence may “come in and out of fashion depending on the need for cost reductions,” write the authors, led by S&P Global’s head of supply chain research Chris Rogers.

“With a focus on cost cutting in 2024, there may be less diversification as companies seek to shorten their supplier lists by pushing more orders to fewer suppliers to get better prices,” they write.

And a certain degree of reversal in diversification may already be taking place. According to S&P Global data, the number of suppliers per company across all industrial sectors, which rose in 2021 as manufacturers sought to hedge risks by using more suppliers, has now declined to pre-pandandemic levels.

That observation would broadly comport with work by economists at the Bank for International Settlements, who find that while supply chains are lengthening, they are not getting more dense—which would be an indication of greater diversification.

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