Fighting inflation entirely with rate hikes isn't ideal

Congress ought to step up, but it probably won't.

Back in May, I explained why rising interest rates are bad for stocks, especially bad for tech stocks, and especially especially bad for startups. To value a company, investors project a company’s future profits and then discount those profits based on current interest rates. The higher interest rates are, the more future profits get discounted, and the less valuable companies will be. And this effect will be more pronounced for fast-growing companies, since a larger share of their expected profits are far in the future.

This explanation is correct as far as it goes, but I don’t think it’s sufficient to explain the truly massive swings in the value of tech startups we’ve been seeing recently. I’ve been thinking about this a lot in recent months because I’ve been investing in lidar startups,¹ and the value of those stocks seems to swing far more than you can explain with discounted-cash-flow analysis.

If the S&P 500 loses 2 percent, the average lidar stock will lose something like 5 percent. I don’t think a discounted-cash-flow story can explain movements that large. I think two other factors are important.

• Many early-stage tech startups need to raise more money before they reach profitability. Tighter financial conditions mean that they’ll have to pay more for this extra capital. When a company’s stock price is low, it has to give a new investor a larger share of the company in order to raise a given dollar amount of capital. And this means that existing shareholders will get less of the company’s eventual profits.

• In a period of tightening financial conditions, with a recession on the horizon, customers are likely to be tightening their belts and hence are less likely to buy new and untested technology products. Obviously, lower revenue is bad for any company, but it’s an existential risk for a startup in a race against the clock to reach profitability before its funding runs out.

And these two effects reinforce each other. Weak revenue growth will make investors more skeptical about a firm’s survival, and therefore more reluctant to put up a new round of funding. And customers may be reluctant to buy a company’s products if it seems in danger of going out of business in a couple of years.

The upshot is that the Fed’s tightening campaign poses an existential risk to a bunch of early-stage tech startups—including some whose ideas would have been perfectly viable in the easy-money environment of the 2010s. The higher interest rates get, the harder it will be for startups with promising but expensive ideas to raise the capital they need.

Now, the venture-funded startup world got pretty silly in recent years, so some degree of tightening was probably appropriate—even overdue. Moreover, the Fed needs to get inflation back down to its 2 percent target. If that means nuking some promising startups in the process, that’s a cost worth paying.

But it is a real cost—not just for those companies but for the economy as a whole. Preventing promising technology products from coming to market will slow the pace of technological progress, at least slightly, over the next five to ten years.

You can tell a similar story about the real estate sector. With a nationwide housing shortage, we should be building new homes as fast as we can. The higher interest rates go, the harder it will be for homebuilding projects to pencil out, the more homebuilders will worry about a 2008-style housing recession, and the fewer homes they’ll build.

In short, the Fed is trying to bring inflation under control by clobbering the portions of the economy that are most sensitive to interest rates. Because these sectors account for a relatively small portion of overall spending, the Fed might have to impose a lot of pain on these sectors in order to bring the economy-wide inflation rate down to the Fed’s 2 percent target.

The difficult politics of fiscal tightening

And so it would be nice if our inflation-fighting strategy didn’t lean quite so heavily on rate-hiking by the Fed. Specifically, Congress can and should reduce demand with a package of tax hikes and spending cuts. In a (paywalled) post for his excellent newsletter, Matt Yglesias argues that an advantage of fiscal policy is that it can be targeted at people who can afford to tighten their belts.

“Since we are specifically trying to curb consumption, it needs to be affluent people broadly construed, not a tiny number of super-rich billionaires,” Matt writes.

This could mean increasing tax rates on people in the upper half of the income distribution, reducing the growth of Social Security benefits for upper-income seniors, cutting farm subsidies, adjusting Medicare’s reimbursement formulas, not canceling student loans, or a bunch of other possibilities.

Of course, writing out a list like that makes it clear why this is unlikely to happen: upper-middle-class taxpayers tend to be well informed and well organized, and members of Congress could pay a high price for angering them.

Moreover, raising taxes or cutting spending during a period of inflation runs contrary to the intuitions of many voters. Many people think that the government should provide people with more, not less, financial support during a period of high inflation. That’s why California is currently sending out checks to its residents, which will help the check recipients but is likely to (slightly) worsen national inflation in the process.

And this is ultimately why we’re relying so heavily on the Fed. It’s structured to be independent of the elected branches of government and hence insulated from political pressures. It uses esoteric policy levers that largely impact voters indirectly. This means Fed actions don’t attract the same kind of backlash as a tax hike or spending cut.

So while rate hikes probably aren’t the best way to fight inflation from an economic perspective, it’s the most politically palatable way to get the job done. And it’s certainly better than letting inflation rage out of control.

1. Normally I avoid writing about companies in which I’m a shareholder (you can see the full list here) for ethical reasons. But I’m making an exception here because this isn’t a post about any specific lidar company—or about the prospects of lidar technology generally. Rather, it’s a post about startup valuations that uses lidar companies as a convenient jumping-off point.