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Shipping Costs: Latest Inflationary Pressures That Complicate Monetary Policy

Missile attacks in the Red Sea and drought-driven slowdowns in the Panama Canal are disrupting shipping in these critical corridors, boosting freight charges and raising the risk of resurgent inflation. This is happening as U.S. domestic inflationary pressures, including shelter and services categories, continue to be supported by strong growth and a tight labor market – exemplified in the January U.S. Consumer Price Index (CPI) report. The confluence of these global and domestic factors complicates the outlook for Federal Reserve policy, and may delay rate cuts past the current midyear guidance from Fed officials.

Macro Signposts regulars will notice our growing concern that inflation in the U.S. – and possibly globally – might sequentially reaccelerate, stalling much of the progress made on the year-over-year rates of inflation closely watched by central bank officials to gain confidence that their policies are working. Factors that have cooled inflation recently – such as declines in core goods prices and the waning of pandemic-era supply chain bottlenecks – are vanishing, while the U.S. economy is growing beyond its potential and a tight labor market is supporting wage inflation (and, by extension, the inflation categories that are the most sensitive to wages: rents and services). Higher prices for imported goods as a result of increased shipping costs could add to these inflationary pressures.

While we don't expect inflation anything close to what we endured after the pandemic, persistent or worsening shipping cost issues coupled with a still strong U.S. economy could be the difference between core CPI inflation drifting down to the "2-point-something" range, or hanging above 3% this year. Although that seems marginal, it could be enough to keep the Federal Reserve on hold through the summer.

Conflicts in the Middle East are also consistent with one of PIMCO's secular economic themes: Geopolitical tensions are likely to arise more frequently as the world moves from a unipolar to a multipolar world. This plus several other global transformations – renewable energy, supply chain shifts, and technological transformation (all of which require significant physical investment) – are likely to keep both global demand and inflation more volatile relative to the persistently subpar growth and below-central-bank-target inflation that prevailed before the pandemic.

Treacherous waters

What's happening? Since the start of the year, attacks by Houthi militants on container ships in the Red Sea have prompted about a third of vessels to ply alternate routes (i.e., a third of global container shipping goes through the Red Sea, and many of those ships are being rerouted). Many are being rerouted thousands of miles around the Cape of Good Hope in South Africa, adding costs and lead times to the procurement of global goods. Compounding these issues, since December drought has forced the Panama Canal (which relies on rain to replenish the canal with fresh water) to reduce traffic by a third.

All of this has contributed to a persistent rise in costs on certain shipping routes (mainly China to Europe and China to the U.S.), which have jumped around 200% since the turn of the year, according to Freightos, representing a nearly 4-standard-deviation increase above the average.

How supply chains affect inflation

Surprisingly, before the pandemic, little academic research existed on the economic impact of supply chain disruptions. Post-pandemic, the most comprehensive study we've found is an IMF Working Paper, "Shipping Costs and Inflation." Increases in shipping costs will likely directly affect the prices of imported goods, which should increase proportionately with the cost of shipping. However, higher shipping costs could also raise the cost for producers, and potentially delay the volume of goods produced and available for consumption.

The IMF study estimates that a 1-standard-deviation shock increase in the Baltic Dry Index (BDI) historically has driven developed market (DM) headline inflation (measured by the year-over-year rate) higher by around 15 basis points (bps), and core inflation by around 10 bps, in the 12 months following the price shock. For emerging markets and some smaller open economies, the effects are greater. A similar analysis on container shipping costs produces similar general results (i.e., for every 1-standard-deviation increase in container shipping costs, core inflation should rise around 10 bps), although the shorter history of container freight rates leaves the pandemic period as the primary episode for measuring the pass-through.

The sharp rise in shipping costs in the past several months, which is largely concentrated in the container freight market, is just under a 4-standard-deviation event, retracing around 20% of the dramatic total increase in the cost of shipping during the height of pandemic-related disruptions. Extrapolating from the IMF paper's model, the effect on EU and U.S. headline inflation could be around 60 bps for headline inflation or 40 bps for core inflation. Applied to our current 2024 year-end forecasts, core U.S. CPI inflation would rise closer to 3.5%, while PCE (personal consumption expenditures, the Fed's preferred measure), would rise to 3.0%.

That said, there are a number of factors that could mitigate the inflationary effects of this most recent rise in shipping costs. First, we ask whether the increased costs will be persistent. They have been in 2023 and so far this year, but if shipping costs decline, the inflationary impact would be lower. Most container freight is based on prices negotiated six months to one year in advance. As a result, prices must stay elevated for a while before producers and wholesalers actually feel the sting.

More important, the IMF estimates rely heavily on data from the COVID-19 period, when the combination of elevated demand for global manufactured goods, extreme shipping bottlenecks at key ports, and limited shipping capacity drove major disruptions to both the price of shipping and the volume of goods delivered. This reduced global finished goods inventories and contributed to stockouts – out-of-stock conditions in one or more categories of goods – that likely exacerbated the surge in goods price inflation both in the U.S. and around the world. We're very far from these conditions today. Unlike the pandemic, the ripple effects of the current situation look very contained.

Still, even if we cut in half the potential inflationary impact, Fed officials would still need to raise their median 2024 year-end core PCE forecasts, possibly pushing up the 2.4% median (as of the latest Summary of Economic Projections (SEP) in December) to 2.6%, which is in line with their median PCE forecast from September when they were also projecting the fed funds rate to end 2024 at 5.1% (vs. the current median projection of 4.6%). We note this is well above the 4.2% fed funds rate priced in the overnight index swap market for December 2024.

On balance, we expect some pressure on goods prices

Global shipping issues will probably provide some upward pressure to goods inflation, although far from as dramatic of price moves as what we witnessed during the pandemic. While this might not derail central banks from normalizing policy this year, higher shipping costs coupled with a still strong U.S. economy do elevate the risk of the Fed delaying cuts, all else equal, and could contribute to a stop-start easing policy, once the Fed does begin cutting.

Moreover, if the Middle East tensions and related shipping issues start to affect volumes of goods being delivered (and not just the cost to ship them), the inflationary effects could be much more pronounced – a very unwelcome environment for central bankers.

This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out to us, please email [email protected].

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