Would Lowering Interest Rates Be a Magic Bullet for the Economy?
In the last few years, due to printing money and low interest rates, inflation has become a big problem in the U.S. economy. This has happened in past administrations, the most notable being the 1970s, which was called the time of “Great Inflation.” At the time, Paul Volcker was the FED chair and he reduced inflation by increasing the Federal Funds rate to a whopping 19 percent in 1981 and inflation eased to 2 percent by 1983.
Volcker’s tough on inflation stance is Jerome Powell’s current strategy. Powell believes if we raise interest rates, it will slow down the economy and decrease inflation. While it sounds good in theory, I don’t think the FED’s strategy of raising rates can get us out of the high inflation predicament we are in. In fact, there is an argument to be made that lowering rates is the only way to bring inflation down to anywhere near their target 2 percent. Let’s dive into the numbers so I can explain this to you.
The Consumer Price Index, or CPI, is broken down into eight categories. One of these categories is shelter. Shelter accounts for one-third of the CPI, so if shelter prices substantially rise, the inflation numbers increase drastically. So while inflation came in at 3.7 percent across the board last month, shelter came in at 5.7 percent. This shows us the real problem in the inflation numbers is housing.
Housing has very little to do with interest rates, and a lot to do with supply and demand. In the time of the “Great Inflation,” we had an overabundance of housing. When rates increased, this made shelter prices decrease, as you would see in a traditional raising of interest rates environment. What is currently different is we have a deficit in the supply of houses on the market. This deficit creates a problem for the FED because even with high interest rates, there is no supply to let the market pricing naturally decline. To get shelter inflation under control, you need more supply. There are two ways to achieve more supply on the market and both of them involve lowering interest rates.
The first reason lower rates would create a housing supply is it would allow people to list their homes. Currently, many people would love to move, but the 3-4 percent interest rate they are locked into prohibits this. If rates dropped dramatically and were closer to 5 percent, people would take a slightly higher rate to be in a home that fits their needs, but most people wouldn’t take on an 8 percent interest rate to do so.
Secondly, lowering rates would increase supply because it would increase building. Most of you probably don’t pay attention to this, but anything you see being built now is only being completed, not started. This is because construction loans are currently sitting around 10 percent. I know in my company, MC Companies, we have put six apartment projects that we haven’t started on hold until rates are at a more reasonable level. This is going on with developers all over the country.
However, lowering rates isn’t a magic bullet. Low rates will stimulate the economy and create more inflation. Lowering rates would only help the housing piece of the CPI. Printing money and extremely low interest rates put the U.S economy in this situation and with the lack of supply of housing, this is uncharted territory. It will be interesting to see if the FED can get us back to 2 percent inflation or if they accept a higher inflation benchmark in order to start lowering rates later this year.
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