On Wednesday, the Federal Reserve raised its benchmark interest rates three-quarters of a percentage point, its most aggressive hike since 1994. This move – likely to be followed up by another hike of 50 to 75 basis points in July – is the economically orthodox response to soaring inflation: Cool overheating markets by dampening demand.
The issue is that today’s inflation is not textbook inflation. It is a supply-side problem. Rather than employment and wages, much of today’s inflation can be attributed to shortages of physical production capacity, including in critical, capital-intensive sectors like energy and semiconductors. But the Fed’s interest rates mechanism – like most of the conventional anti-inflation tools available to the US government – is a demand-side response. Moreover, aggressive interest rate hikes risk worsening this physical capacity shortage by discouraging the private sector investments necessary to increase supply.
This is not to say that the Fed shouldn’t raise rates. But it does mean that an effective response to inflation – and to the more systemic supply demand mismatch that threatens the US economy – requires pairing the Fed’s monetary policy band-aids with investment in supply; in production of critical resources ranging from food to energy, the processing and manufacturing built on top of them, and the systems of exchange, like shipping logistics and pipelines, to transport them.
As the lightning rod political issue of the moment, skyrocketing inflation has been blamed on any number of factors ranging from corporate greed to lax monetary policy, climate policy to lack thereof. The merit of those various arguments varies. All of them miss the point: For decades, the US has under-invested in production; instead of building things has built reliance on convoluted, international supply chains. These disproportionately depend on geopolitical adversaries. They are inordinately vulnerable. They rest on the assumption that the world is a rational, peaceful place.
With that assumption proving false – whether in the form of global pandemic or a land war in Europe – these supply chains are being turned on their heads. The result is a crisis of supply. That crisis of supply has been exacerbated by a demand-side response to it (think stimulus checks, low interest rates, loan freezes). Cue inflation. Now, the Fed is trying to walk things back. But its tools are still demand side. Which means that the US is trying to fix inflation not by raising supply to meet demand, but by lowering demand to wallow with supply.
What if, instead, the US government was to promote supply-side growth? What if, in addition to immediate monetary policy quick fixes, Washington was to set about investing in production of critical inputs, manufacturing facilities, and improved logistics systems? What if Washington was to use today’s crisis to rethink its permissive approach external dependencies; to make sure that the US can make more – and more of what is foundational to economic functioning — at home and with trusted partners.
The US needs more than immediate, reactive, tactical measures to today’s economic crisis. It needs a gameplan for domestic resilience so that this crisis does not continue indefinitely and does not recur.
The US needs more than immediate, reactive, tactical measures to today’s economic crisis. It needs a gameplan for domestic resilience so that this crisis does not continue indefinitely and does not recur. The first step in this gameplan is upstream: Identification of the most critical inputs into today’s, and tomorrow’s, industry – think buzzword areas like cobalt and lithium, but also the unignorable basics like agricultural products, pharmaceuticals, steel – and investment in those. The next step is the manufacturing, processing, and distribution infrastructure necessary to take advantage of those; pipelines to transport natural gas, say, but also solar panel module factories. And the third step is investment in improved freight and logistics systems to connect and protect the supply chain.
None of this program is something that the US government should, or can, undertake alone. These are projects for the private sector. But the private sector needs a push from Washington: Tax credits (and penalties), regulatory flexibility, and public private partnerships, for example, that adjust short term incentives to align them with long-term interests – of companies and of the country.
This is also a program that demands allied cooperation. America’s northern and southern neighbors have critical roles to play: Canada is a natural resource giant and, increasingly, a source of cutting-edge industrial advance. Mexico offers manufacturing prowess and labor at a time when both are scarce in the US. Europe, directly challenged by the disruptions of the Russia-Ukraine war, is more incentivized than ever to flex its industrial policy muscle. And America’s East Asian allies are leading the charge in new energy technologies critical to securing a robust industrial future.
This is not a typical response to inflation. And it is certainly not a short term fix for it. However, investing, intelligently, in supply is the only way to break not only the inflation wave, but also the inflation cycle.