Last week, the Federal Reserve approved the first interest rate hike in more than three years, hinting that more are to come. This will very likely impact our already fragile and embattled supply chains – which in turn will affect consumers and the various products we need and buy on a regular basis. Will we pay more for products beyond the already soaring inflation? Are more shortages to come? The answer is more complex than it seems.
Over the years, the physical costs associated with carrying inventory have decreased due to automation and increased efficiency, while the financial costs of carrying inventory have become more prominent. When it comes to supply chains, interest rates impact the per-unit holding costs, so as interest rates go up, so too does the holding cost per unit. And, as holding costs increase, companies order less and reduce their inventory.
We’ve seen this happen time and again historically. During the post-dot-com bubble from 2002-2008, interest rates began to climb rapidly and only dipped slightly just before the global financial crisis in 2008. When we look at the inventory-to-sales ratio, which is the average time inventory sits on the shelf or warehouse, we can see a general decrease.
In other words, as interest rates increased, inventory decreased, and companies were forced to become more efficient because they couldn’t afford to be negligent with their money.
It’s important to note that while changes in interest rates are generally smooth, the same does not apply to inventory. The financial world is neat; supply chains are messy.
After the financial crisis in 2008, interest rates remained very low for a long time – and indeed, inventory increased.
The main thing to notice here, apart from the trend, is the time lag. Inventory began climbing only a little after 2012 because it took time for people and businesses to recover from the recession. Since supply chains involve people and physical products, they tend to have a slower response time.
From 2016 to 2019, just prior to the pandemic, interest rates started to steadily increase again, and companies started reducing the amount of inventory they carried.
The overall trend is clear – but what does that mean for us today?
I do expect overall service levels to remain somewhat the same. Both the cost of overstocking, which is driven by the holding cost and cost of materials, and the cost of understocking, which is driven by profit margins, are expected to increase. This will likely result in a somewhat similar target service level.
But with interest rates on the rise, firms will begin to carry less inventory, and that inventory will be more expensive due to the increase in the inventory cost per unit. Thus, we should expect more stockouts and to pay more for the products we need.
But, if we have learned anything from our brief review of the last 20 years, these supply changes will be somewhat lagging and not as clear as their financial counterparts. As long as the situation remains gradual, it will take a while until we really feel the impact…at which point it will be too late to react.
What can companies do? Over the last few years, there are more solutions available around supply-chain financing. This financing can help firms get paid earlier and more efficiently. And reduce the impact of these increases on consumers.
What can the government do? There are industries where we want to ensure there is enough inventory. For example, do we really want to go back to shortages of PPE or semiconductors? Given the increases in the price of cars, we want companies to be able to carry inventory, but we don’t want to inflict the higher costs of carrying inventory. While I am not advocating providing loans to these companies at this stage, if interest rates continue to climb, finding a way to help them finance their working capital can be a useful way to curb this inflationary pressure while maintaining high availability of key products, and lessening the financial burden on consumers.
After two years of experiencing stockouts and price increases as a result of the pandemic, consumers are becoming used to these pressures. They don’t have to be, though, and we can try to curb the impact if we learn from the past and take steps to better protect our financial future.
Gad Allon is the faculty director of the Jerome Fisher Program in Management & Technology at the University of Pennsylvania in Philadelphia.