The financial sector is still roiling from the failure of Silicon Valley Bank. At the epicenter of factors triggering the collapse is the Federal Reserve’s strategy of hiking interest rates. This would be a good time to ask: How else might we tamp down inflation?
Rapidly ratcheting up interest rates is intended to “cool down” the economy by inducing unemployment, or at least reducing job openings. Policies that lower labor demand make it easier for companies to compete for employees without triggering so-called “wage-price” inflation. And lower employment, in turn, also means there are fewer people with “excess wealth” demanding goods and services and thus driving inflation.
The alternative is an economy that meets or over-supplies goods and services. Such an economy is disinflationary because it drives competition and thereby lowers prices. Economists like to point out that such supply-side solutions are “time-consuming to implement.” They are. So too are the effects of rate hikes. As Congressional Research Service economists wrote recently, it can take “from 18 months to several years for the effects of Fed policy changes to feed through to inflation.”
Inflation-reducing, wealth-creating supply-side options are given short shrift for a simple reason. While the Fed controls interest rates, Congress controls the taxes and regulations that can limit supply-side expansion. Of course, Congress also controls inflationary spending. Acknowledgment of that reality was on display at a congressional hearing earlier this month when Senator Elizabeth Warren told Federal Reserve chairman Jerome Powell that “your tool, raising interest rates, is designed to slow the economy and throw people out of work. So far you haven’t tipped the economy into recession, but you haven’t brought inflation under control either. Maybe the reason for that is other things are keeping prices high, things you can’t fix with high interest rates.”
The magnitude of the headwinds the Fed faces will be determined by those “other things.” What could be done to systemically increase the supply of goods and services? Three factors produce abundance: cheap energy, stable and efficient regulations, and access to risk capital. Unfortunately, policymaking trends point away from those goals.
Start with energy. When it is cheap and readily available, Americans take it for granted.
Policymakers understand the importance of energy prices. Few things invoke anxiety in the political class as much as high gasoline prices because voters feel the effects immediately. Consider how quickly the Biden administration, despite its hostility to the oil industry, moved to issue temporary exemptions to regulations constraining truck deliveries of fuel to the East Coast after the 2021 cyberattack on the Colonial Pipeline. Or consider that long before the Ukraine war, the administration authorized the sale of an unprecedented quantity of oil from the Strategic Petroleum Reserve to moderate prices. Meanwhile, inflationary actions, such as cancelling the now-infamous Keystone XL pipeline, don’t have the same overnight impact.
Until recently, the U.S. has experienced a steady decline in the share of the total economy devoted to paying for fuel and food (both deeply energy-price dependent). That trend has reversed.
Current federal policy seeks to use subsidies, grants, loans, and mandates to increase radically the supply of energy from wind and solar power. Eventually, the bill will come due for the consequent underinvestment in oil and gas production. And as U.S. grids try to absorb more episodic power production, residential electricity prices will continue, even accelerate the upward trend, as they have in every place where the share of supply from solar and wind has risen.
For a stark example of the eventual impact of federal (and many state) energy policies, look to Europe. As it tries to reduce its dependence on cheap Russian energy—the U.S., meantime, apparently wants to reduce its dependence on cheap American energy—the underlying costs of Europe’s energy path now threaten a broad deindustrialization. BASF, one of the world’s biggest chemical companies, announced layoffs and plans to move operations out of Europe permanently. The company’s CEO was candid when he said, “Europe’s competitiveness is increasingly suffering from overregulation, slow and bureaucratic permitting processes, and in particular, high costs for most production input factors.” Notably, the CEO pointed to the dual challenge of high energy costs and overregulation.
Congress did next to nothing about the labyrinthine and onerous regulatory system that affects constructing all big projects, even as the Infrastructure Act of 2021 and the Inflation Reduction Act of 2022 plan to direct massive spending on traditional infrastructures, roads and bridges, along with the favored hardware of the “energy transition”—windmills, solar farms, and batteries. Even before the flood of subsidies enters the market, ambitious wind and solar plans are already encountering the kinds of delays that all big projects do. And now, the new U.S. subsidies have prompted an inflationary escalation of similar subsidies in Europe.
But regulatory sclerosis is far from limited to the energy-producing industries. The energy-hungry business of fabricating semiconductors and computer chips—now also stimulated with massive subsidies, courtesy of the CHIPS Act—will have to deal with both hidden bureaucratic compliance surprises (such as hooks into hiring practices in exchange for federal handouts) and the absence of any collateral changes to siting, construction, and environmental regulations. That industry’s trade association has warned about “burdensome reviews” and wants the government to “streamline and expedite” the processes. (Good luck with that.) Thank headline writers at The Register in the U.K. for framing the challenge as follows: “Semiconductor industry: To Hell with the environment, start building fabs already.”
The same headline could apply to any industry that seeks clarity and speed from the government for projects that sustain a modern society. That includes the underlying critical commodities and minerals essential for manufacturing medical devices, smartphones, solar modules, and electric-car batteries. Constraining domestic expansions of underlying commodities not only increases imports and those associated economic impacts (as well as geopolitical risks), but also raises input costs and inflates the price of whatever gets produced. Today’s economists learned their trade after a 100-year period of slow decline in key mineral prices. In the twenty-first century, that trend has reversed.
In March 2022, Chairman Powell presciently observed that the “added near‐term upward pressure from the invasion of Ukraine on inflation from energy, food, and other commodities comes at a time of already too high inflation. In normal times . . . monetary policy would look through a brief burst of inflation associated with commodity price shocks. However, the risk is rising that an extended period of high inflation could push longer‐term expectations uncomfortably higher.” One suspects that the chairman is aware of the other things that will continue to cause commodity inflation.
Which brings us to the third factor underpinning disinflationary business expansion: access to capital. Whatever unfolds from the SVB failure, it will surely result in congressional and federal agency reviews and new financial regulations. The inherent lack of visibility of what those rules will be, in addition to the heightened uncertainty in capital markets, will cause so-called risk capital to dry up. Yet America’s economic dynamism and technology leadership depends on businesses’ willingness to spend on new ventures, especially risky technologies. The SVB failure will likely chill the broader funding ecosystem for startups and entrepreneurs involved in all manner of industrial, manufacturing, or medical technologies, not just the favored or derided.
This is happening contemporaneously with Congress letting expire a tax benefit that encouraged business investments in new hardware and equipment—the kinds of assets that bring long-term productivity gains and therefore lower costs. The impending pullback of private capital comes at a particularly bad time. One of the biggest challenges for inflation-fighters in the coming years is demographic: not enough people able and willing to work. Last month’s job-formation numbers, for instance, remained stubbornly high despite the Fed’s “best” efforts.
Aside from a deep recession, labor shortages can be solved only with more babies, more immigrants, or more technology. The history of civilization has been characterized by putting technology to work to amplify human labor. What makes our era different is the confluence of an unprecedented demographic contraction at the same time as the arrival of the unprecedented labor-enhancing technologies of artificial intelligence and robotics. But it is an inherently risky business to improve and put to work new classes of AI-based software tools, ones similar to but more useful than ChatGPT. The same is true for the new class of mobile robots that can safely work alongside or instead of humans in heavy industries.
It would be hard to imagine governments in earlier times standing in the way of the adoption of tractors that replaced horses and helped food production skyrocket. But that’s the equivalent state of play today. At the same time, sadly, we’re on track to see more of the “other things” fueling inflation. Policymakers should be trying to help the Fed. After all, voters have lots of patience for spending on favored causes in boom times, but much less in recessions.
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