Memo to Fed: lower interest rates are overdue

The inflation news continues to get better. Indeed, inflation has beaten official expectations for the past two years—yet the Fed remains cautious. Fed-watchers are familiar with this: the Fed is always slow to catch on to the prevailing fundamentals. They waited too long to tighten (as they did throughout 2021, despite abundant evidence that M2 had exploded and measured inflation had surged), and then they waited too long to ease (not cutting rates until in late 2024, almost 18 months after inflation had fallen from 9% to 3%). 

In the past (before the Fed adopted an abundant reserves policy), such mistakes had severe consequences: once policy became tight enough to slow the inflation fueled by a delayed response to higher inflation, the economy invariably suffered a recession. Today it looks like we will avoid a recession, but that doesn't ensure we won't see some housing market turmoil. Liquidity in the housing market is terribly low and prices are unsustainably high, all on top of a surging inventory of homes for sale. And to the chagrin of would-be home buyers, 30-yr mortgage rates are hovering just under 7%—which equates to a crushing real interest rate of about 5% per year. If Fed policy had been more responsive in the past decade to swings in inflation, mortgage rates today would be far lower. 

Meanwhile, in the good news column, today's May inflation report showed that consumer prices on average rose a mere 0.1% in May, and are up only 2.4% in the past year. However, excluding shelter costs (which are now widely understood to be a seriously lagging statistic that effectively overstates current inflation), the CPI is up only 1.5% in the past year. Abstracting from shelter costs, consumer prices have risen at a 1.8% annualized rate for the past two years. In other words, inflation has been below the Fed's target for a full 2 years. Long-time readers will know that I first made this point two years ago.

Memo to Fed Chair Powell: lower interest rates are not only justified but long overdue.

Chart #1

Chart #1 illustrates the relatively large gap between headline inflation and inflation ex-shelter costs. This gap has been narrowing for the past two years (though the narrowing has been slower than I thought it would be). Excluding shelter costs, consumer price inflation has been less than 2.0% year over year in 19 of the past 24 months; on an annualized basis, ex-shelter inflation has been 1.8% over the past two years. 

Chart #2

Chart #2 shows the portion of the CPI that corresponds to shelter costs: Owner's Equivalent Rent makes up about one-third of the CPI. Shelter cost inflation by this measure has been declining for over two years. 

Chart #3

Chart #3 shows how the year over year change in housing prices 18 months ago feeds into the OER component of today's inflation. (I have shifted the red line 18 months to the left to show this.) The most recent evidence of housing prices shows that in most areas of the country, home prices are roughly flat to down. This all but ensures that the OER component of the CPI will subtract meaningfully from consumer price inflation for the next year or two.

P.S. The FOMC meets next Wednesday, so that's the earliest we could see a rate cut. However, the market is betting that there is almost no chance the Fed will lower rates next week. The market is not expecting any cuts until the September 17 FOMC meeting, and only a 20% chance of a cut at the July 30 meeting. That seems like an awfully long time to me.