How supply chain disruptions are driving up inflation and how we can deal with this

Our economy depends heavily on global supply chains. While this works very efficiently in stable times, it also leaves us vulnerable to disruptions abroad. The risk of disruptions has increased due to this international interdependence and heightened geopolitical tensions. Recent events, including the war in Iran and, previously, the chip shortages and the energy crisis following Russia’s invasion of Ukraine, have shown how quickly regional shocks can have global repercussions. When the production or supply of goods or raw materials is disrupted anywhere, delivery times increase, economic activity slows down and prices rise.

Vulnerability to disruptions increases when the production of a raw material or commodity is concentrated in one or a few countries. This is especially true for goods that are vital to sectors such as healthcare, defence, energy and digital infrastructure. The greatest risks often arise at the start of the supply chain, particularly when it comes to semiconductors, raw materials and rare metals. Disruptions at that stage can ripple through much of the global economy, including Europe and the Netherlands.

Supply chain disruptions are driving up inflation

Due to the increased interconnectedness of the global economy, supply chain disruptions are causing the risk of inflation to rise. Disruptions not only cause shortages of specific goods, but also have wider repercussions for the production of goods and services and for economic activity. This drives up costs for businesses, which are then passed on to their customers and ultimately paid for by consumers. This process is gradual and can prove persistent: even after the initial disruption to the supply chain has subsided, inflationary pressures will persist for some time.

The impact of supply chain disruptions on inflation vary: sectors and countries that depend more on imported raw materials and goods are hit harder when disruptions occur. The left-hand figure, ‘Inflation responses’, shows how inflation responded to past supply chain shocks. The impact differs by product category: some prices rose sharply, while other prices increased only slightly or with a delay.

Central banks, such as the European Central Bank, respond to rising inflation by raising interest rates. This will slow down the economy and help bring inflation back under control. This approach is effective when price rises are caused by excessive economic activity. However, it is less effective in situations when price rises are caused by shortages of raw materials and goods due to supply-side disruptions.

Higher interest rates cannot solve shortages of raw materials or goods, as the source of inflation remains. At the same time, they can weigh heavily on the economy: investment falls, growth slows down and employment may come under pressure. In other words, the social costs can be substantial.

Targeted action and European cooperation

Because combating inflation comes at a high social cost, it is better to prevent supply chain disruptions where possible. This requires targeted government action, because businesses and consumers cannot address these vulnerabilities on their own. Effective action requires coordination at national and European level. Reducing vulnerabilities not only benefits individual parties but society as a whole.

These vulnerabilities often affect specific raw materials and goods, rather than entire sectors. The right-hand figure, ‘vulnerabilities in the supply chain’, shows that usually only a small number of goods within specific sectors are truly vulnerable. This calls for a targeted approach, such as scaling up production quickly, diversifying suppliers or building up strategic stocks. Looking ahead is essential, because vulnerabilities can shift as technology and production processes change.

European coordination is essential in this regard. Some Member States are better positioned to expand the production of specific raw materials or goods, by drawing on existing expertise, infrastructure or economies of scale. For example, scaling up the supply of chemical products makes most sense in countries that already have a strong chemicals cluster. By coordinating policy at European level and building on national strengths, Europe can reduce vulnerabilities more effectively than countries acting alone. The European single market also provides an important buffer: when supply disruptions occur, it helps ease shortages and makes it easier to switch more quickly to alternative suppliers within Europe. A strong and innovative European economy therefore offers protection against future dependencies.