Taming inflation — and stabilizing the increasing prices of everything from gas to food to used cars — is the greatest economic challenge facing the US. Many people, including President Joe Biden, are looking to the to solve the problem.
The problem is the Fed has one tool to slow rising prices: interest-rate hikes. Basically, inflation is caused by a mismatch between supply and demand. While raising rates can control some forms of inflation, it does so by crushing the demand side of that equation, making it more expensive to take out loans or make investments. This leads to slower economic growth, fewer businesses expanding their operations, and higher unemployment. Americans already feel poorer today because of increases in the costs of food and energy. The Fed’s strategy for slowing down these price increases? Make those same Americans even poorer.
Thankfully, there is another way. There are a few notable places where White House and Congress can step in to help slow inflation without crushing average Americans. Policymakers in Washington can follow a three-point plan to tackle inflation:
- On the supply side, they can make direct investments in productive capacity to increase the amount of goods that businesses can deliver.
- They can pass measures that push companies to bring prices down through greater competition and technological diffusion.
- On the demand side, they can use policies far more targeted than the Fed’s interest-rate hammer to surgically reduce demand in specific sectors.
Following this threefold plan would allow Biden and lawmakers on Capitol Hill to slow inflation without cutting into much-needed new investment or throwing people out of work. Unlike interest-rate hikes, these strategies would counter inflation at its root and have more direct, identifiable, and predictable effects on key prices.
Investments to enhance and preserve productive capacity
Much of today’s inflation comes from an acute shortage of physical capacity in capital-intensive sectors. There simply aren’t enough factories and experienced workers to make the basic things we need, from oil to semiconductors to housing inputs. Add in the disruptions caused by COVID-19 and the war in Ukraine, and you end up with inflation measures at multidecade highs.
But while these issues are coming to a head now, the physical limitations of our supply chains are the result of decades of cost cutting and downsizing by companies in response to weak demand after the financial crisis. The capacity cuts alongside reduced investments in new manufacturing facilities and a push for more “efficient” business strategies left a fragile system that broke during the pandemic.
To build back this capacity, the US government should make direct investments to increase physical production capacity and encourage businesses to follow up with their own. This would help stabilize prices in the near term while strengthening the economy in coming years. In particular, Washington should push for increased investment in the production of major commodities: energy sources like oil and gas, metals like aluminum and copper, and agricultural inputs like potash and wheat.
Employ America has already laid out a plan for accelerating investment within the American oil industry. The first step is to allow the Strategic Petroleum Reserve, a reservoir of oil controlled by the federal government, to sell physical put options — contracts that guarantee the government will buy a barrel of oil at a certain price in the future. Oil producers are reluctant to invest in new equipment because they’re concerned that the price of oil will have fallen again by the time their investment comes online. But by providing insurance with these contracts, the government can alleviate that concern and incentivize these producers to build new facilities to pump oil. The Biden administration can then use the Exchange Stabilization Fund to make financing for these new investments more affordable and invoke the Defense Production Act to coordinate production to increase the supply of parts used in extracting oil like steel pipe and fracking sand.
However, these production increases would be meaningless if we fail to preserve existing energy capacity. This is particularly true for refineries, where crude oil is processed into products that cars and other machines can use. More than 1 million barrels a day of the nation’s refining capacity has shuttered as a consequence of low demand early in the pandemic. In a promising move, the Biden administration has begun inquiring about keeping open some refineries scheduled to close and restarting recently shuttered refineries. The administration should also help keep two nuclear-power plants in Michigan and California online to increase the supply of energy and ease the burden on oil producers. Without investments to maintain and restart existing energy assets, we could be looking at power outages across multiple states and persistently higher prices at the pump.
Another important segment of the US economy dealing with capacity issues is the housing market. Despite the strong labor-market bounce-back and elevated activity in both the rental and the home-sales markets, over 1.6 million housing units are still mired in construction backlogs — the highest number of in-progress units in decades. Over half of these incomplete units are multifamily buildings that could help alleviate pressures stemming from rapidly increasing rental demand. Quickly completing these new homes is critical given that the US faces a shortage of nearly 4 million homes (or more, by some estimates) to accommodate the population.
Congress and the administration should explore mechanisms for directly funding and addressing the additional costs associated with the backlogs in residential construction, particularly where single-material inputs, like plastic resins and aluminum, remain in short supply. And Congress can consider direct measures, like the Low-Income Housingand the Housing Trust Fund, to fund new housing and encourage homebuilders to increase supply even as the economy shifts.
The Bipartisan Innovation Act would also, helpfully, reduce costs for firms already investing aggressively to ease arguably the most impactful “core inflation” bottleneck: semiconductors. Insufficient semiconductor production capacity is affecting the prices of several durable goods, most notably automobiles. Most of the supply of vehicles that would be required to bring prices back down is sitting in factories waiting on a handful of semiconductors. Once those chips become available, that bottleneck will become much wider, with significant disinflationary effects. Congress should also consider further appropriations for the Defense Production Act fund that could be flexibly deployed to address bottlenecks in critical industries.
Targeted demand reduction
There are two key areas where Congress and the Biden administration could slow inflation by directly reining in costs: healthcare and higher education. Reforming the way the government pays businesses in these sectors could significantly affect inflation in a more equitable and closely targeted way than interest-rate hikes.
In healthcare, the administration should follow up on reforms originally made as part of the Affordable Care Act to establish fixed prices for services, regardless of where that service is rendered (site-neutral payments, in the jargon). Today, the same outpatient treatments can command substantially different prices depending on whether they are performed at a hospital or the office of an independent physician. By standardizing the amount medical providers can charge for these procedures, the administration would immediately reduce public spending as well as waste and fraud.
While the government can standardize costs only for Medicare and Medicaid patients, in the longer term these reforms would help increase the bargaining power of insurance companies over providers to do the same for private healthcare plans, potentially lowering deductibles and premiums for all Americans. One study from the Chicago Fed found that similar reductions made as part of the ACA contributed to persistently weaker inflation between 2014 and 2016.
The federal government exerts even more authority over universities and colleges than over healthcare. Federal funding, in one form or another, accounted for 14% of college revenue in 2018. The federal government should place a cap on the amount by which colleges can raise tuition or require schools to commit to bringing costs down for students in other ways in order to keep receiving funding.
The final arrow in Biden’s quiver for fighting inflation is policies that enhance competition between firms. Two unexpectedly linked industries would particularly benefit from this: telecommunications and air transportation.
Widespread 5G adoption has been stymied because the frequencies used for the new cellular service are close to those used by airline altimeters, which help a plane determine its height. To avoid issues, telecoms have not installed 5G towers near airports, and airlines have been pushing to upgrade their equipment. But both the altimeter upgrades and the 5G rollout have been slow, and regulatory action to speed up the process would be helpful.
But what does this have to do with inflation? On the telecoms side, expanding 5G coverage would amount to a “quality adjustment” in inflation readings, helping bring down the overall figure the same way unlimited data plans did in 2017. Passing the Bipartisan Innovation Act — which would appropriate money that could speed up efforts to ensure 5G rollouts are compatible with existing aircraft and equipment — would remove barriers to universal 5G adoption. And universal expansion would force more price competition among cellular providers.
Funding airport-gate expansions would help drive down a disproportionate source of inflation over the past two months: airfares. While rising airfares likely reflect a recovery from the pandemic and the outsized effects of jet-fuel price spikes, increasing the number of gates at airports would lower the barriers to entry for lower-cost airlines. Demand for air travel will likely remain robust for the rest of the year as Americans look to make up for lost vacations — all the more reason to encourage price competition as soon as possible.
As Robert Frost once wrote, there is “no way out but through.” Inflation is at levels not seen in decades, but there are nearly as many causes as solutions. An exclusive reliance on interest-rate increases risks setting back an incredible jobs recovery. Instead, the federal government should use every tool at its disposal to relieve price pressures in a more equitable and direct manner. These policies could dramatically reduce inflation over the coming years without ending a historically strong labor recovery.
Alex Williams is a research economist at Employ America, a think tank working towards full employment.