Opinion | The Federal Reserve should cut interest rates now

Jim Parrott is co-owner of Parrott Ryan Advisors and a nonresident fellow at the Urban Institute. Mark Zandi is chief economist of Moody’s Analytics.

It’s time for the Federal Reserve to declare victory in its war on inflation and cut interest rates.

The Fed’s aggressive rate hikes have helped cool inflation, but its insistence on keeping rates higher for longer is based on a serious misjudgment of the role the cost of owning a home plays in inflation and threatens to do unnecessary harm to the economy.

The Fed targets inflation as measured by the change in the personal consumption expenditures (PCE)deflator, which tracks the prices of a representative mix of goods and services purchased by the typical American. By this measure, inflation peaked at well over 7 percent two years ago, and while it has fallen to below 3 percent today, it still remains well above the Fed’s 2 percent target. The widely followed consumer price index shows a similar pattern.

These are, however, flawed measures of inflation, relying heavily on an ill-conceived notion of the cost of homeownership. Both attempt to capture the cost of homeownership by estimating the rent a homeowner would pay for a similar home nearby. This is problematic for two critical reasons.

First, using this rental equivalent approach badly miscalculates the actual cost of owning a home when the costs of renting and owning diverge, as they have in today’s market. The vast majority of American homeowners either don’t have a mortgage or have the same fixed-rate mortgage they had last year, and are paying similar housing costs. Yet their implicit rent has gone up along with that of actual renters.

The rental equivalence approach breaks down further when the owner-occupied stock is different from the stock of rental properties. It is virtually impossible, for instance, to come up with a useful measure of implicit rent for homeowners in communities where most homes are owner-occupied, or where the rental stock is almost all multifamily and the owner-occupied stock almost all single family. There simply isn’t enough inventory to determine comparable rents, especially during a nationwide housing shortage.

Because of these and other challenges in measuring the cost of homeownership, most developed countries treat owner-occupied housing as an investment and exclude it from their inflation estimates. Yet, in the United States, it’s given more weight than any other good or service tracked in the two preferred measures of inflation. If the Fed followed the sensible lead of the rest of the developed world and removed this variable from its measures, it would find that inflation is right on its target at 2 percent. Indeed, it has been there since last fall.

More important than mismeasuring the cost of owning a home, however, is that the Fed is basing its ongoing higher-for-longer strategy on a misunderstanding of what’s actually driving the high cost of homeownership. While raising interest rates weighs on the prices for most goods and services by reducing demand, its impact on the cost of homeownership is more complicated.

The primary driver of the painfully high cost of owning a home is a long-standing supply shortfall. For years, the supply of homes to rent or own has fallen well below demand in much of the country, sending rents and home prices alike to historic highs. The situation was exacerbated by the covid-19 pandemic, which severely disrupted the supply chains and labor needed to build more homes.

High interest rates have made the situation still worse by making it harder and more expensive for builders and developers to finance new construction. Added to the still-elevated costs of land, labor and materials, they have made building new homes simply too expensive in many parts of the country. Moreover, higher rates are making many homeowners understandably reticent to give up their much lower mortgage rate and put their homes on the market.

This breakdown in the housing supply pipeline is lifting the cost of buying and renting, driving up the very measure of inflation on which the Fed is relying. The tool the Fed is using to drive inflation down is doing precisely the opposite.

This puts the Fed in something of a box. It has repeatedly said it is targeting 2 percent inflation as measured by the PCE deflator. If it changes course now, investors might conclude that it is moving the goal post, calling into question its commitment to low and stable inflation. But if the Fed explains why it is focused on the more reliable inflation metric used by most other developed nations, the credibility problem should be short-lived. The alternative of holding fast to a flawed metric is indeed likely to do more reputational damage over the long term, so the Fed would do itself a favor by beginning the move to a more accurate measure.

The economy has weathered the Fed’s higher-for-longer strategy admirably well, but there is a mounting threat that the ongoing pressure will expose fault lines in the financial system. As last year’s banking crisis showed, the relentless strain of high rates can cause parts of the financial system to buckle in ways that are difficult to predict and control.

The job market also appears increasingly fragile, as businesses have pulled back on hiring, cut employees’ hours and are using fewer temp workers. They have been loath to lay off workers, but that could quickly give way under the increasingly heavy weight of high interest rates.

There is no reason to take these risks for the sake of hitting a flawed inflation target. Better for the Fed to recognize its hard-fought win against inflation and begin, finally, to cut interest rates.

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