If you ask most people whether increasing the supply of goods over time helps reduce inflation, the overwhelming answer is “yes.” After all, more supply means less scarcity, which should ease price pressures. Similarly, if you ask whether companies are more likely to invest in long-term projects when they can borrow at lower interest rates, most people would again say “yes.” Cheaper capital means more investment, which leads to greater production capacity.
Yet, when the conversation shifts to interest rates and inflation, many of those same people argue that raising rates is the most obvious way to reduce inflation. The contradiction is striking. If increasing supply is a long-term solution to inflation, and lower rates encourage investment in supply, why do so many believe that higher rates were the only appropriate response for the post-COVID inflationary environment?
The Demand-Side vs Supply-Side Assumption
The prevailing belief among policymakers is that inflation is primarily a demand problem. When interest rates rise, borrowing becomes more expensive, reducing consumer spending and business investment. This demand suppression, in theory, should cool inflation. But what if inflation isn’t just a demand-side issue?
The inflation we experienced in recent years can, at least in part, be attributed to supply challenges. Housing shortages, energy constraints, labor market tightness, and supply chain disruptions were all major inflationary forces. Yet raising interest rates to curb demand also discourages investment in these critical areas, making supply issues potentially worse.
Take housing as an example. The Federal Reserve has explicitly stated its goal of making home prices and rents more affordable. However, higher interest rates increase financing costs for homebuilders, reducing new construction. At the same time, higher interest rates clearly increase mortgage payments and with so many homeowners locked into low mortgage rates from our Zero Interest Rate Policy (ZIRP) era less likely to sell, housing mobility is preventing supply from efficiently meeting demand in many parts of the country. The result? Elevated home prices even as demand weakens.
The Onshoring Boom and the Role of Interest Rates
The push to reshore manufacturing and supply chains to the U.S. is viewed as critical for economic resilience but faces significant challenges. Building semiconductor fabs, clean energy projects, and new manufacturing plants requires massive upfront investments, which are highly sensitive to borrowing costs. Elevated interest rates raise the return hurdle for these long-term projects, potentially slowing onshoring and prolonging (or even increasing) supply constraints.
To address these challenges, policymakers are reducing regulatory burdens, offering tax incentives, and allocating billions in government funding to support critical projects. While these measures help offset costs and improve project economics, interest rates still play a pivotal role. For onshoring to succeed, a combination of favorable policies and a supportive interest rate environment is likely essential.
Interest Rates as an Investment Tax
Interest rates should at least be at a level where there is a meaningful cost of capital, ensuring that capital is allocated productively. The era of free money, through ZIRP, was not a sustainable or effective policy. Instead, rates should be set at a level high enough to deter speculative behavior and gambling in financial markets, but reasonable enough to encourage productive private investment, especially when paired with tax incentives and deregulation.
A useful way to think about interest rates is as a tax on investment, collected by savers at the expense of borrowers. Businesses make investment decisions based on their cost of capital and expected demand. When borrowing costs surge, new projects must clear a much higher profitability threshold, which can stifle innovation and growth. This is particularly problematic in industries that require long-term investments in supply, such as housing, energy, and manufacturing. When capital becomes too expensive, companies don’t build more… they build less. This further constrains supply, which can counteract the intended disinflationary effects of higher interest rates.
Therefore, the goal should be to strike a balance: rates should be high enough to prevent reckless speculation but low enough to avoid stifling productive investment. This balance, combined with supportive policies like tax incentives and deregulation, can create an environment where capital is allocated efficiently, fostering sustainable economic growth.
Rates Are Likely Moving Lower: The Case for Cuts
Given the current economic landscape, there is a strong argument that interest rates are likely to trend lower, irrespective of whether one views lower rates as inherently disinflationary. With the lagging effects of monetary policy, there is a growing risk that the Federal Reserve could fall behind the curve if it fails to act decisively. This would not only help prevent destabilization of the financial system but also support broader economic expansion.
Putting it All Together
While higher interest rates may effectively suppress demand, they can also undermine the supply-side investments essential for addressing inflation sustainably. A more balanced and nuanced strategy, one that combines demand management with policies aimed at boosting supply, could provide a more effective pathway to achieving long-term price stability and economic growth as the economy rebalances.
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