North American equity markets have continued to push higher through the first month of the year. Given the anticipation for lower interest rates, all eyes remain focused on the world's central banks. This past week, the Bank of Canada decided to maintain interest rates at existing levels, as expected. While Bank of Canada Governor Tiff Macklem emphasized that it's too soon to talk about rate cuts, a subtle shift in his language suggested growing confidence that inflation's downward trajectory could be maintained in the current rate environment. This week, we turn our attention to an emerging issue: the challenges facing the global shipping industry, which could have implications for the inflation outlook.
Two of the world's most important shipping channels, the Suez Canal in the Red Sea and the Panama Canal, have faced major disruptions in recent months. The Suez Canal is estimated to account for more than 10% of global trade and is especially crucial for trade between Europe and Asia. The passage has been compromised by Houthi rebels in Yemen who began attacking ships in November, prompting military responses from the U.S. and U.K. Traffic through the canal has declined substantially as shipping companies have re-routed vessels around the southern tip of Africa, a detour which invariably takes longer and costs more.
Meanwhile, a severe drought has resulted in historically low water levels and meaningfully reduced traffic capacity in the Panama Canal. While it accounts for a smaller amount of global trade than the Suez, the Panama Canal's disruption more directly impacts the Americas, and the United States in particular, as it represents a key trade route with Asia.
These shipping disruptions have resulted in a sharp increase in some shipping costs in recent months, which marks a significant change from the declines witnessed over the past few years. Higher freight rates may have limited effect for the time being as many companies are shielded by longer-term shipping contracts. However, there have been a few signs of supply chain disruptions emerging in certain industries. For example, some European car manufacturers have paused production due to delays in receiving auto parts from Asia. On the other hand, retailers across other industries have reported that they are holding sufficient inventories, allowing them to be patient for the time being.
While longer transit times and elevated shipping prices may persist near-term, there are some reasons to believe transportation costs may not reach the extremes witnessed just a few years ago. Firstly, the pandemic-induced supply shock led many companies to diversify their supply chains and hold more inventory, which may leave them somewhat less vulnerable to major disruptions. In addition, new shipping capacity is coming online as vessels ordered during the pandemic and built over the past few years finally become ready to sail. Moreover, demand for goods is expected to remain weaker than a few years ago because of the impact of higher interest rates.
Even so, we will be closely monitoring the length and intensity of these disruptions. The longer they last, the more they may lead to challenges across a broader swath of the global economy. Though companies have less pricing power than they did when demand was stronger, some pass-through to consumers may be unavoidable. This could add some stickiness to inflation, thereby compounding the challenges facing central banks, which are hoping to see inflation fall further in order to deliver on investors' expectations for interest rate cuts.
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