Supply Shocks? We’ve Had a Few. Here’s How Investors Can Deal

On this episode of The Long View, Claudia Sahm, chief economist at New Century Advisors and past section chief at the Federal Reserve, discusses the origins of the Sahm rule, how to interpret Fed-speak (it’s not Klingon), the integrity of economic data, and more.

Here are a few excerpts from our conversation with Sahm.

Moving around interest rates doesn’t affect the labor force. It doesn’t affect productivity.

Claudia Sahm

Amy Arnott: How should investors think about things that are happening, like the war in Iran and supply shocks like the Strait of Hormuz? There are so many unknowns and unknown follow-on effects. Is there a reasonable way to think through potential outcomes and what the potential impact might be on the economy?

Claudia Sahm: Right. So first, stepping back just from the most recent events in the Middle East, it’s been the case now for five or six years, really since the pandemic, the US economy has had a whole series of these supply shocks, cost shocks. In the pandemic, we had disruptions to supply chains, and there were certainly some labor force disruptions; people were afraid of becoming ill or did become ill, so that you had some real disruptions in the labor force from the pandemic. We’ve had large increases in tariffs, we’ve had the war in Ukraine, and now the conflict in the Middle East to push up energy prices. There’s just been a whole series and then big swings in immigration, which is also kind of fundamental to the economy. And so what economists refer to as “supply shocks,” we can think about them as kind of fundamental to the economy, like the inputs, the costs that businesses face, the costs that the consumers face.

And it’s kind of unusual to have had such a string of these. Often, the shocks that the Fed is trying to think about are whether we have some big burst of demand, maybe we have a big tax cut, or we have big refunds going out to households, or we have a recession that’s a real collapse in demand. So, that’s kind of the typical thing that moves around the economy, but we’ve had this whole series of supply shocks. And one thing that is particularly problematic about them is that when they’re the bad kind of supply shocks, they can both push up prices, push up inflation, and push down on growth. And they can often do both at the same time. In the 1970s, this was referred to as “stagflation.” We’re not in a space like that, but we’re definitely where there’s this tension. I will say that sometimes we can have good supply shocks, and they’re in the mix right now, too.

There’s certainly been a push with some deregulation, which we can argue about whether that’s a net good or not, but I mean, that kind of moves in the direction of it can push up growth and push down inflation. But another big one that is just at the kind of start is the AI rollout into the economy that has potential in pushing up productivity, pushing up growth, and pushing down inflation. So, we’re dealing with these supply shocks, which are not typical. They’re not ones that the Fed is really well-suited for. Moving around interest rates doesn’t affect the labor force. It doesn’t affect productivity. And it’s not clear whether we’re just in a string of bad luck or there have been policy decisions, but it’s a tough setup. It’s certainly a tough setup for the Fed, but I will say it’s a tough setup for investors or businesses, regular people trying to navigate these shocks.

When I talk about it as a whiplash economy, we’ve also had them in rapid succession, and many of these have been really big shifts. And so it’s hard to know how to respond to them, frankly. And even once you have a response, there are a lot of costs in adapting to the changes. And so I think what you’ve seen with the Fed, which I think is a pretty broad approach to this environment, is you kind of fall into a risk management mode. It’s not just about what you think is the most likely thing to happen in the economy, what’s the most likely thing to happen as we move through tariffs, we move through the conflict in the Middle East, or we move through the AI revolution—it’s about managing around and staying away from the worst-case scenarios, like kind of being ready to pivot as soon as you have enough information.

Then you have to do a lot more scenario analysis. You have to be kind of testing, having a sense of what to look for in the worst-case scenarios, and responding to that. So it’s a little different than just having your base case and responding to that. You really have to think about the whole distribution of risk and position yourself so you’re ready to move when it becomes clear which direction is the right direction to move.

On Gas Prices: ‘Will They Go Higher?’

Ben Johnson: Claudia, so much great stuff to unpack here. The one thread I wanted to pull on: the impacts of these supply shocks that your average American consumer is experiencing when they pull up to the gas pump. And you’ve made the distinction historically about the data that the Fed is looking at, key data points like CPI, and then the data that your average consumer is most concerned about, which is, “I’m paying on average maybe more than $4 a gallon for gas.” How do you think about reconciling those? How do you think that the Fed has to navigate this distinction between what shows up in the data and what shows up in just sort of sentiment, and most prominently, maybe paying at the pump?

Sahm: Right. The biggest question right now for the Fed in terms of the effects of the conflict in the Middle East on inflation is not so much about where the gas price is right now, it’s about, “Will they go higher? How long do they stay at this high level?” And actually a big question for the Fed, the big worry that they have, particularly now that inflation has been above the Fed’s target for a full five years at this point, even before we had the conflict in the Middle East. And they’re worried that people, businesses just take it as given that inflation’s now 3%, inflation’s just going to be higher. What’s really remarkable, when you talk about the sentiment surveys, sentiment is absolutely abysmal right now. And I think it makes sense also in this context of that whiplash economy, of a whole set of supply shocks. The reason sentiment hit an all-time low this month is not just about what’s happened with gasoline prices going to $4 a gallon.

That certainly added to it. That was the latest leg down, but we have seen, really since 2022, Americans in these surveys pointing to prices as the reason that they are falling behind year after year. So, this has just been a continual getting hit with these unexpected price shocks, and that’s what’s weighing on sentiment. What’s been really interesting, and as far as the Fed’s concerned, kind of encouraging, is that when you ask these same households and these surveys to look out five to 10 years, “What do you think inflation’s going to be?” Despite the fact that we have had multiple price shocks that they’ve dealt with, they’re still kind of hanging in there that inflation’s going to come back down because that’s the piece. It’s not just about where we are right now in terms of gas prices or in terms of inflation; it’s, “Are we going to get stuck here?”

And so far, the indications both on what’s actually happening in the Middle East … there is some path to getting back to something that would look like normal. And so far, consumers are with that, and that’s really important for Fed policy going forward. But so I think some of this disconnect between when you look at different pieces of economic data, you look at the sentiment surveys, you look at financial markets, a lot of it’s like different horizons. What’s embedded in those data? I think they do still all hang together. And in fact, in the sentiment surveys, there is something encouraging in that most people, when they’re asked, still see this as a temporary hardship in terms of higher inflation, not a permanent one.

Compiled by Valentina Djeljosevic.

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