Maybe Lower Interest Rates Would Actually Cool Inflation

Maybe Lower Interest Rates Would Actually Cool Inflation
Paul Allison, CFA

21 days ago3 mins

I know I probably sound like a mad scientist here, spouting wild theories to get attention. And, of course, I’m aware that interest rate hikes are the widely proven, most effective tool for bringing down high inflation. And, yes, I’m also aware that lowering rates probably won’t lead prices lower. Still, I do see the logic in the argument that lowering rates now won’t rekindle rampant inflation, and could even knock it down in one crucial area.

This chart shows the components of the closely watched consumer price index (CPI). And it’s hard to miss that massive 32% that comes from shelter – all things housing-related. The shelter component itself is made of four things: rent, owner equivalent rent (OER, which is basically the cost of owning your own home), lodging away from home, and home insurance. Most of these are tied to house prices.

Now it’s true that US house prices have come down a bit (close to 10%, actually), but given the dramatic run-up in interest rates, that drop isn't exactly huge for buyers. By now most of us are familiar with the reasons. Buying a new home means taking out a new mortgage (unless you’re fortunate enough to be paying cash, of course). And because most Americans have locked in low rates for 30 years, a lot of homeowners are staying where they are. And that means there are very few houses coming on the market. Last year saw a steep, 40% drop in the number of homes that changed hands.

But back to my wild theory: what if the Federal Reserve (the Fed) didn’t wait for inflation to drop to its 2% target or for a surge in joblessness and opted instead to cut interest rates anyway? Most people say that’d risk a big run-up in inflation again. But I’m not convinced. If the link was that direct, then you’d think that current higher rates would’ve killed inflation. And they haven’t, not quite. Of course, they’ve helped shrink it, but inflation is still hanging around, and most of the drop in annual price increases is down to the cycling of the previous year's big price jumps. In other words, prices aren’t coming down, they’re just going up by less.

So what I’m saying is this: if the Fed starts to chop into rates this year (as expected), it’d certainly bring a whole lot of dormant home sellers back into the market. That added supply could lower shelter prices further, which might put pressure (downward pressure that is) on a massive swath of the CPI – that 32% that is shelter.

The only thing to consider, then, is what the unintended consequences might be. You could argue that the US economy isn’t all that sensitive to interest rate changes, especially since US consumers and businesses never really stopped spending even as interest rates went higher and higher. So, from that standpoint, maybe it wouldn’t spark a big run-up in inflation.

Admittedly, this theory isn’t born from a massive empirical data study, and I (probably) won’t be submitting it for a Nobel prize. But I bet it’s being discussed – at least quietly – in the corridors of the Fed as the central bank weighs whether to cut rates early this year or not.



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