Are High Interest Rates Still Reducing Inflation?


Written by Philip Diehl

Jun 27, 2024

On June 12, 2024, Federal Reserve officials announced that the central bank had not yet seen enough progress on the inflation front to cut interest rates, and they lowered their projections for the number of rate cuts this year from two to one. This was big news because only a few months ago, expectations were for three cuts in 2024.

Some critics, including an array of prominent economists, worry that these restrictive policies will lead to a recession.

What are the implications of the Fed’s caution on interest rates?

I’ll start by saying I’m skeptical about most of the old rules that guide these economic predictions. I’m persuaded many of them no longer apply. The pandemic, its scrambling of supply chains, the disruption of labor markets, the erosion of globalism, the changes in U.S. fiscal policies, the war in Ukraine, and the West’s sanctions on Russia have fundamentally changed the global economy in ways that are difficult to grasp. One of the big tasks analysts face is figuring out which rules are still useful and which ones belong in the dustbin.

This uncertainty presents a difficult challenge for monetary policymakers, and it’s a major reason why the Fed is proceeding so cautiously while guided by the most recent data on inflation, employment, retail sales, producer prices, and inflation expectations. The Fed is flying the economy through a thick fog, relying on instruments that penetrate the gloom only so far. I’ve been critical of the Fed since I started dealing with it 30 years ago, but I give it high marks for getting us close to a soft landing with the runway approaching.

We’re almost there—but we’re not there yet. And I do share economists’ concerns that the Fed is at risk of keeping its monetary policy too tight for too long.

Monetary policy operates on a lag. Tight measures adopted months ago are only now working their way through the marketplace. This is widely recognized and lies at the heart of the concerns of many Fed watchers.

I have a different concern about the Fed’s policy. 

Conventional wisdom says that high interest rates are crucial to squeezing the last remnants of inflation out of the economy. I don’t doubt that high rates have helped reduce inflation from its peak of 9% to its current rate of about 3%. But I do have doubts that keeping interest rates high will finish the job.

Why? Because, in the past, high interest rates have done most of their work by suppressing the housing market. High rates reduce spending on new housing construction; raise mortgage rates, thereby reducing demand for new and existing housing; suppress spending on furnishings for new homes; and reduce demand for labor in all those sectors. These pressures have reduced inflation in the past.

But today’s housing market is very different from that of yesteryear. The key to understanding the difference lies in understanding that many homeowners are “locked” into their current houses by the low mortgage rates they hold.

Many homeowners today have interest rates below 4% because they financed or refinanced their homes two or more years ago when rates were low. If they were to sell their homes and buy new ones today, they'd would be trading in mortgages with rates at 3% or 4% for rates at 7%.

Many homeowners are not ready—or can’t afford—to do that and are thus “stuck” in their current homes. If those homeowners are stuck, then anyone who might otherwise sell a house to them is likewise stuck in their home. And anyone who might want to buy a “stuck” homeowner’s house? Well, they’re stuck too. We face a housing logjam.

Because so many homes are off the market due to high interest rates, housing prices remain high. And when you combine high mortgage rates with high home prices, you have high housing inflation.

How do you lower inflation in this environment?

You lower interest rates. This reduces the lock-in effect of homeowners with low mortgage rates. Reducing the lock-in effect increases the supply of housing. Greater supply leads to softer prices. Softer home prices and lower mortgage rates reduce housing inflation. 

This line of thinking may seem counterintuitive, and it certainly runs counter to conventional wisdom, but the COVID-19 pandemic scrambled the old rules—and it’s time to think differently. 

We should lower interest rates sooner rather than later, not only to avoid a recession but also to finish the job with inflation. 


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