Jacquelyn Martin/AP Photo
Federal Reserve Chairman Jerome Powell attends a news conference following an Open Market Committee meeting on June 15, 2022.
The U.S. economy has a short-term problem and a more enduring long-term problem. The first is high inflation and hence decreasing real wages, which makes it hard to sustain growth in an economy mostly dependent on consumer spending. Second, over the past 50 years we have seen a troubling drop in investment—whether for infrastructure or industrial activity or basic necessities—that has inflated the cost of things like housing and health care while leaving the nation vulnerable to supply crunches caused by the pandemic and Russia’s war on Ukraine.
The decided-upon cure for the short-term problem—rising interest rates from the Federal Reserve—is degrading the long-term problem. What’s more, it’s unlikely to make more than a small dent in rising prices.
Millions of Americans are going to be deliberately thrown out of work because an economic model says that’s the only way to blunt inflation, while the seed corn of the next generation is eaten and the basic investments we need to sustain a productive economy are put off.
The Fed’s preferred tactic is demand destruction. They want to reduce Americans’ capacity to spend money, bringing it more in line with available supply. Larry Summers said this out loud the other day, arguing that the nation must increase the unemployment rate to 5 percent for five years in order to bring inflation in line. It’s at 3.6 percent now, which roughly speaking means that two to three million people must lose their jobs for the foreseeable future, in Summers’s perfect world.
The Rube Goldberg–like mechanism for getting this done is that the Fed raises interest rates high enough so it’s costlier for businesses and individuals to borrow. These borrowing costs are rising more rapidly than at any time since the early 1980s. If it works as intended, that will eventually filter down into less consumer spending, reduced hiring and wages, and lower inflation.
We’re already seeing this work. The housing market’s decline, with home sales now falling over the past couple of months, is a direct result of mortgage rates rising over 6 percent, in line with both Fed actions and the expectation of more interest rate hikes in the future. That amplification—the benchmark interest rate is only at 1.75 percent now, but mortgages are much higher—is replicated to some degree in corporate and Treasury borrowing.
In short, what higher interest rates do is crush investment across the board. As Skanda Amaranth of the research group Employ America explained on Tuesday, Federal Reserve tightening doesn’t just hit the demand side of the equation, but the supply side as well. And this comes precisely at the time when more investment is desperately needed.
Take the housing market, for example. The mortgage rate shock reduces home sales. But we know from experience that a sagging market will also reduce home completions. After the housing bubble collapsed, we had serious disinvestment in new housing. Importantly, this lasted for a decade, as homebuilders grew wary of adding units into a sclerotic economy, lest they be unable to sell new homes. This underbuilding is a major reason rents and home prices have rocketed over the past year, and has made it hard to grow out of the problem, as key inputs like lumber consolidated during the depressed years and cut their capacity to the bone.
When investment is held back, critical infrastructure withers, inventories deplete, institutional memory gets lost, reshoring grows more difficult, and dominant firms build more market power.
Though 2022 is expected to be the biggest year for housing completions since 2006, Amaranth points to permits and starts falling amid the rougher conditions. We all know that we need more housing in America. But the market’s cyclical nature means that the Fed’s measures to slam housing will make the home-building gap worse over the long term.
You can apply this logic to virtually everything that policymakers want. There’s a desire to bring semiconductor manufacturing to the U.S., to create good-paying jobs and sustain reliable supplies of computer chips. But as borrowing costs rise, that investment will simply not stretch as far. Congress already passed an infrastructure law to better move goods across the country and increase resiliency to climate-fueled weather events. But that law is now stunted because of billowing financing costs. We urgently need to invest in a green transition to prevent the worst ravages of the climate crisis. That just got more expensive, too, and companies that might have invested in green energy could be priced out.
When investment is held back, critical infrastructure withers, inventories deplete, institutional memory gets lost, reshoring grows more difficult, and dominant firms build more market power amid lack of investment from rivals. It’s a ghastly scenario, and it’s mostly self-inflicted.
Even worse, the Fed’s strategy might not cure the disease. It’s hard to attribute inflation entirely to an economy running hot when there hasn’t been any economic stimulus in 15 months and fiscal policy has now turned sharply negative. What looks to be the greater problem is a simple shortage in physical capacity to sustain a decent standard of living. The main pockets of inflation right now are in fuel, which is rising because of supply shocks from Ukraine and a bottleneck in refining capacity; food, also stunted due to the war; and housing, damaged by a decade of underbuilding. Investment is needed to deal with all of these categories, but thanks to the Fed, investment is now harder to do. Indeed, researchers from the Federal Reserve Bank of San Francisco itself recently concluded that problems other than demand account for about two-thirds of current inflation.
We are moving toward an economy with higher interest rates, flat consumer spending, depleted personal savings, higher unemployment, and potentially a recession. And none of it may have any effect on inflation, which is mainly caused by random supply crunches. In fact, the Fed’s cure could make things worse, by preempting the ability to boost supply. It will certainly make things worse over the longer term, where the supply-boosting needs are most acute.
There are other options to take. The original version of Build Back Better would have lowered long-term cost of living in a host of areas, from health care to education to housing, in some cases by specifically boosting supply. What may come out of Democratic negotiations can still help with prescription drug costs and energy production, and the competitiveness bill is intended to invest specifically in supply chain resilience for critical goods. Ocean shipping reform has the potential to wring out extortionate transportation costs. We can restructure markets vulnerable to supply shocks, like baby formula. And Employ America has released a host of ideas, from advance market commitments that incentivize energy supply by guaranteeing prices, to lowering health care costs with administrative actions, to using Treasury authority to fund commodity production.
But unless we get aggressive, we won’t get the investment we need for our economy. And unfortunately, the Fed is focused on dragging demand back down to supply rather than letting supply catch up to demand. Elected officials are doing little to counteract this, despite the real damage we will see over the long term, as the long-term investment in our productive capacity fades away.
