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Why the FED cannot lower rates yet.

The FED will have difficulty lowering rates because when mortgage rates fall, home buying becomes more attractive, forcing prices higher on the largest component of inflation.


For most homebuyers, their monthly payment, or what they can afford monthly, matters much more than the absolute price of a home. Most people do not buy a home with cash. Redfin found that as of December 2023, 66% of people used a mortgage to buy a home. Two main components determine the size of a monthly mortgage payment: home price and interest rate.


The FED focuses on inflation. Although it leans heavily on PCE, which tends to be better at showing trends than short-term fluctuations, it is still relying on CPI to gauge inflation's temperature.


The table below shows the most recent CPI reading. The fastest growing areas annually are Transportation Services, Shelter, Services less Energy, and Food away from Home. However, the table is not a good way to examine how each category affects CPI since each category is weighted by the BLS, which calculates CPI each month.


Even though Shelter is only the second fastest-growing category, it far outweighs the other categories. The second table below from the Pew Research Center shows that Shelter accounted for about one-third of the basket in 2021. So, no matter how the other categories perform, the FED has to pay special attention to Shelter.

Also, although many other categories are peripherally tied to interest rates, housing is particularly sensitive to changes in interest rates.


This is why the Fed is stuck. There is already a shortage of homes. If the Fed cuts rates, it will make homes more affordable on a monthly basis. This will mean more buyers. More demand will drive up prices even higher, compounding inflationary pressures.


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