Wall Street analysts recently voiced concerns over how the current Bullwhip Effect complicating supply chains (especially retailers) could also complicate the Federal Reserve’s strategy for reducing inflation. Their theory is that the current bullwhip is severe enough to trigger deflationary pressures at the retail level that will prematurely induce a U.S. recession. This could force the Fed to alter course on its contractionary monetary policy before the optimal point necessary to tame inflation over the long-term. The purpose of this brief is to examine the plausibility of this theory by analyzing relevant market-level conditions behind the theory to determine if the bullwhip could ultimately affect monetary policy.

The Bullwhip Effect (BWE) is a phenomenon characterized by amplification of demand variability from retailers up through the supply chain. Several causes of the BWE exist. However, the recent bullwhip is likely driven by government stimulus payments to individuals, limited supplies, and longer lead times during the coronavirus disease (COVID) pandemic. As a result, suppliers are likely rationing inventory, leading channel members to engage in shortage gaming by overordering (Mitchell, Quarterly Journal of Economics, 1923). This further augments the problem.

This BWE is unlike any other. Channel members lack historical data and guidance for exiting a pandemic-induced economic shutdown. For two years, retailers have been building inventory for select merchandise categories only to be faced with changing consumer behavior. Some customers are cutting back on nonessential spending to combat inflation. Others have shifted spending to services or to alternative product categories. With excess inventory, retailers are relying on markdowns and cancelling orders to combat higher inventory holding costs and limited warehouse space. Some retailers are even adapting return policies by offering refunds and asking customers to keep the merchandise. The result will be downward price pressures increasing the possibility of a recession.

To gauge the potential impact of the BWE on inflation, its severity is first established by analyzing U.S. Census Bureau seasonally adjusted average monthly sales and inventory holdings data for U.S. general merchandising retailers (U.S. Census Bureau, 2022, https://www.census.gov/mtis/index.html). This allows for coverage of a wide variety of retail products while simultaneously excluding food and energy. The latter two experience well-documented price volatility which could skew conclusions about the BWE’s severity. Census data also contain the aggregate average monthly inventory-to-sales ratio that, similar to Obermaier (International Journal of Production Economics, 2012), is used to measure the severity of the BWE. This ratio represents a firm’s efficient use of inventory relative to sales, with a lower ratio indicating efficient inventory utilization. A substantial uptick in this ratio likely signals an increase in a firm’s inventory holdings while simultaneously failing to increase sales, the exact effect expected during a BWE.

As illustrated in Online Supplemental Appendix Fig. 1, general merchandise retailers experienced sustained improvement in their operations prior to the March 2020 COVID emergency declaration. Specifically, retailers reduced inventory-to-sales ratios from a maximum of 1.50 to a minimum of 1.32 over the 60 months prior to March 2020. This represented a 12% reduction with a cumulative monthly growth rate of -0.16%. This improvement was achieved via moderate sales growth and major gains in inventory utilization efficiencies. The ratio continued its decline during the first year of COVID, reaching a minimum of 1.16. However, this continued reduction was the result of quick retail inventory turnover caused by amplified sales activity fueled by government stimulus and new consumer needs emerging during the stay-at-home orders. This unusual activity marked the beginning of the BWE.

As the BWE accelerated, retailers struggled to efficiently replenish inventory sold due to issues related to demand amplification in the supply chain. This placed inflationary pressures on future sales. Retailers continued to rebuild inventories even as inflation began and as consumers adjusted to a changing set of consumption opportunities related to the evolution of risks associated with emerging from COVID restrictions and the resulting availability of goods and services. As a result, retailers found themselves carrying excess inventory no longer in demand with consumers adapting to higher prices and changing their behaviors. As a result, the average inventory-to-sales ratio reached a minimum of 1.16 in March 2021 before an immediate reversal increasing to a maximum of 1.58 in May 2022. This represents an increase of 36.21% or a cumulative monthly growth rate of 0.73%. As can be seen in Online Supplemental Appendix Fig. 1, this reversal was quick, substantial, and unlike the gradual changes normally associated with the evolution of inventory-to-sales ratios. This movement is indicative of a BWE. Retailers needed to quickly reduce their excess inventory via deep discounts and other measures to cut costs and shift to products experiencing greater demand.

In conclusion, these inventory reductions could result in deflationary pressures across the retail sector. Any price reductions would likely compress retailers’ earnings and operating cash flows, likely resulting in retail employee layoffs. This coupled with deflationary pressures would be a double blow to the retail supply side of the economy. If these effects are substantial enough, it is plausible that the Fed could react by prematurely reducing its quantitative tightening (QT) activities initiated in March 2022 by halting or even reversing interest rates increases. Further complicating the Fed’s monetary decisions is that it must simultaneously consider the effects of its QT efforts on the demand side of the retail sector as consumers adapt to increasing interest rates. A premature reduction of QT would expose the Fed to the risk of rebound inflation or a diminished capacity to reduce interest rates in the event of a severe economic recession triggered by deflationary pressures. The fruition of either risk would be the BWE’s final crack.