On June 12th, 2024, Federal Reserve officials announced that the central bank had not seen enough progress yet on the inflation front to cut interest rates, and they lowered their projections for the number of rate cuts this year from 2 to 1. That was big news since only a few months ago expectations were for three cuts in 2024. Some critics, including an array of prominent economists, worried that these restrictive policies will lead to a recession.
So I've been asked, what are the implications of the Fed's caution on interest rates? I'll start by saying that I'm skeptical about most of the old rules and rules of thumb that guided these economic predictions in the past. I'm persuaded that 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 policy, the war in Ukraine and the U.S. sanctions on Russia have all fundamentally changed the global economy in ways that are really difficult to grasp.
One of the big tasks analysts face is figuring out which rules are still relevant and useful, and which ones belong in the dustbin. This uncertainty presents a difficult challenge for monetary policy makers, and it's a major reason why the fed is proceeding so cautiously, guided by only the most recent data on inflation, employment, retail sales, producer prices and inflation expectations.
I've been critical of the fed since I started dealing with it 30 years ago, but on this score I give it high marks for getting as close to a soft landing with the runway approaching. We're almost there, but we're not there yet. And I do share concerns that the fed is at risk of keeping 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 it lies at the heart of concerns of many fed watchers. But my concern is different. Conventional wisdom has it that high interest rates are now 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 plus or minus 3%. But I do have doubts that keeping interest rates high will finish the job. Why? Because in the past, high interest rates have worked most of their magic by suppressing the housing market. High rates reduce spending on new housing construction, raise mortgage rates, thereby reducing demand for new and existing housing. It suppresses spending on furnishings for new homes, and it reduces labor demand in all of those sectors. These pressures have reduced inflation in the past. But today's housing market is very different from those of yesteryear.
The key to understanding what that difference lies in understanding how 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 a refinance 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 be trading mortgages with rates of 3 to 4% for ones at 7%.
Many homeowners are not ready or can afford to do that, so they're stuck in their current homes. If those homeowners are stuck, then anyone who might otherwise sell a home to them is likewise stuck in their home. And anyone who might want to buy a homeowners house, well, they're stuck too. It's a housing logjam. So because there are so many homes that 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.
So how do you lower inflation in this environment? You cut interest rates. This reduces the lock-in effect of homeowners who have 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 the conventional wisdom. But Covid has 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. Thank you.
