Time for the Fed to cut interest rates

After three years of increasingly higher prices, consumers and businesses finally are seeing inflation beginning to ease.

Even before 2020, the United States faced a “Great Affordability Crisis.” Rising college tuition and health care costs were driving Americans into debt, while housing and child care costs were growing much faster than wages — causing couples to delay getting married, having children, and buying their first homes.

Supply-chain disruptions caused by a pandemic and an energy shock caused by Russia’s invasion of Ukraine created the perfect storm for inflation. Prices soared further in just about every category. We could see it and feel it at the grocery store, on the lots of car dealerships, and at all points in between.

But as supply chains have been restored and the U.S. has achieved record levels of energy production and independence, inflation is slowing and America’s economy is leading the world.

The Consumer Price Index, the most commonly cited measure of inflation, is at 3% and trending downward. The Federal Reserve’s preferred gauge is at 2.5%.

Another way to measure inflation is to consider all the goods and services typically purchased by Americans but remove housing costs. This is the approach taken by nearly every other industrialized nation. Indeed, European Union countries do not include housing costs in their inflation rates.

Under this methodology, inflation in the U.S. has been at 2% for over a year. In other words, the best way to reach the Federal Reserve’s 2% target is to address inflation in the housing market.

While the Fed’s initial decision to hike interest rates was a policy intervention designed to slow inflation, a decision to keep rates high creates real headwinds for the housing market. Our country has a shortage of 2 million to 4 million homes after two decades of under-building.

High interest rates not only have made it more expensive for families to buy homes, but they’ve also made it more cost-prohibitive for developers and builders to take out loans to finance new construction. High interest rates also have made would-be sellers reluctant to list their homes. Three-fifths of all borrowers have mortgage rates below 4%, and this “lock-in effect” resulted in 1.3 million fewer home sales last year.

This is the primary reason why the Federal Reserve should cut interest rates. It would begin to enable developers to increase the new housing stock and encourage families to “trade up,” creating downward pressure on prices by boosting supply. When supply catches up to demand, home prices and rents can normalize, bringing top-line inflation down to the 2% level for all other goods and services.

But there’s another reason for the Fed to consider action: As a preventive step against recession.

The economy moves in cycles. While the U.S. economy has boomed over the past several years — especially relative to the rest of the world — there have been recent signs of slowing.

In the first half of 2024, the U.S. economy expanded at its slowest pace in two years. The unemployment rate has ticked up by 0.5% over the past 12 months. Although Illinois’ gross domestic product is now $1.1 trillion, it was one of 10 states to suffer an economic contraction in the first three months of this year.

While this is hardly a five-alarm fire, it is a trend that can be controlled by reducing the cost making new investments. Lowering interest rates at a time when inflation is abating can help fix the broken housing market. It also reduces borrowing costs on forthcoming taxpayer-funded infrastructure projects and privately financed energy and manufacturing investments, while improving affordability for families and ensuring that job growth remains strong.

It is time for the Federal Reserve to cut interest rates. This policy change is not only supported by market dynamics, but it would also be welcomed wholeheartedly by the public. Most importantly, it would deliver meaningful relief for American businesses, state governments, and everyday consumers.

• Frank Manzo IV is an economist at the nonpartisan Illinois Economic Policy Institute.