How would Ronald Reagan attack the problem of shelter inflation?

The Fed held the Fed Funds rate at a range of 5.25% - 5.5%, which is where it has been since the last time the Fed hiked rates in July. In terms of holding the Fed funds rate at a consistent level, this will go down as the longest since 2007, and is the second-longest tightening cycle of all time.

There has been a long-running academic battle between left and right economists over the efficacy of Keynsian spending versus Keynsian tax cuts. As you can expect, this one falls right down on ideological lines, with left econ like Paul (Dr. Cowbell) Krugman arguing that government should stimulate the economy by demand-side pump priming. This includes increased welfare spending, things like universal basic income, and a plethora of government subsidies and make-work projects. This is classical left-wing demand-driven Keynsian thinking. It is all about stimulating demand, and it is the go-to solution for whatever ails the economy.

Republicans generally refer to supply side economics as another solution. The left strawmans supply side economics as “trickle down economics,” claiming that the policy is nothing more than cutting taxes on the rich. There is more to it than that, and any tax policy that doesn’t involve raising taxes on Elon Musk as much as Elizabeth Warren would like will be characterized as “trickle down economics” by the media. The funny thing is that Reagan supply-side economics came of age in a period pretty similar to now, and it might make sense if we look at the drivers of inflation today.

Inflation is generally known as “too much money chasing too few goods.” In other words, too much demand and too little supply. Traditionally, the Fed has fixed the problem by attacking the “too much money / too much demand” side of the equation. Raising interest rates encourages saving and when people are saving, they aren’t spending. Rising interest rates often causes economic weakness, which is another avenue to reduce demand.

In the late 1970s, the US was going through a similar economic period, where growth was underwhelming, while inflation was spiking higher. Productivity was lagging as manufacturing plants were reaching the end of their useful lives. This ended up creating shortages and inflation. In the late 1970s, the press created something called the “misery index” which was the sum of unemployment and inflation. The misery index peaked in the late 1970s and early 1980s. The government had pushed a stimulative Keynsian fiscal policy which was characterized by LBJ as “guns and butter” or “we can expand the welfare state while fighting in Vietnam.” Given the US’s military commitments along with the unprecedented amount of fiscal stimulus in response to COVID, we have a very similar economic backdrop.

The net result of these policies were inflation, along with slowing growth. One of the more pernicious effects of 1970s inflation was a phenomenon called “bracket creep.” As inflation rose, workers received cost-of-living adjustments. During the 70s, the tax brackets were not indexed for inflation, so you could have a situation where inflation rises 5%, the worker gets a 5% cost of living adjustment, and is theoretically in the same place as before. Unfortunately that 5% raise pushed the worker into a higher tax bracket, so they ended up worse off.

Ronald Reagan capitalized on public outrage over bracket creep, and vowed to cut taxes. One other thing he did to help reduce inflation was to use the tax code to encourage corporate investment in updated manufacturing capacity. Instead of attacking the “too much money / too much demand” side of the equation, he attacked the “too few goods” side of the equation. He encouraged companies to increase capacity. Corporate taxes were lowered, and the government instituted accelerated depreciation schedules, which allowed corporations to lower their tax burden if they invested in new plant and equipment.

For the most part, the policies helped, especially in industries like steel which found having a mini-mill with a handful of big customers was more efficient than big integrated steel mills which had been around since the mid 1800s. In addition, the oil and gas sector invested heavily into exploration and production, which helped set the stage for US energy independence and lower energy prices overall. Manufacturing did suffer from increased competition, and anyone who follows the Misery Index could see that the Reagan economy was better than the Carter Economy. Much of this was due to supply side economics, and that could hold the key going forward.

Reagan and Volcker had to deal with high food, energy and manufacturing prices. Today, the problem is housing. There isn’t much the Fed can do to encourage home building that won’t be self-defeating. If the Fed cuts rates to make housing more affordable, prices will simply rise in response. If they buy mortgage backed securities to lower mortgage rates, the same thing will happen. Plus the Fed wants to decrease the size of its balance sheet, not increase it.

The problem with housing is supply. The way for government to attack the affordability and shelter inflation problem will be to lower the cost of construction. There are no quick fixes here, and for the most part the government has no plans to remove regulatory costs - only to impose more. But some sort of regulatory relief along with a tweak of the tax code to encourage building would be a start, and chances are it would lead to more affordable new construction.

The problem of course is the political optics of such a solution. The left prefers to focus on solutions like banning hedge funds from owning properties, which is 100% about messaging. The right will probably bristle at having affordable housing units set asides and price ceilings in order to qualify for these tax breaks. That said, the solution to the inflation problem is largely out of the hands of the Fed. It is in the hands of the homebuilders.