In recent months, the U.S. economy has shown signs of cooling inflation, but beneath the surface, a web of interconnected problems remains, placing the Federal Reserve in a delicate and precarious situation. The latest Consumer Price Index (CPI) report, which indicated a year-over-year inflation rate of 2.5%, seems like a modest win in the fight against rising prices. However, as we delve deeper into the broader economic landscape, these victories are only superficial; wages, though rising in nominal terms, are being severely eroded by inflation and rapidly escalating housing costs
The CPI and Wage Disparities
The CPI report shows that inflation has been curbed substantially since its pandemic peak of over 9%, but it remains stubborn in certain sectors—housing being the most significant. Although household incomes grew by 3%, many workers are not feeling the relief in their wallets. For instance, a household with a median income of $80,610 in 2023 may have seen a raise to approximately $82,028, but this increase is being quickly nullified by rising living costs. While inflation in many areas may ease, the cost of housing continues to rise at a rate of over 5% year-over-year.
For a household that spends $2,000 a month on rent, a 5% increase means an additional $1,200 annually, which many times surpasses the nominal wage increase they received.
Housing: The Persistent Crisis
Housing, a sector deeply intertwined with monetary policy, continues to be a major headache for both consumers and policymakers alike. Recent data from the National Association of Realtors indicates that home prices have surged over 5.4% year-over-year, outpacing both wage growth and general inflation.
The Federal Reserve’s rate hikes, implemented over the past two years to cool inflation, have inadvertently exacerbated this crisis by driving up mortgage rates, making homeownership increasingly out of reach for millions of Americans. At the same time, higher mortgage rates have pushed more people into the rental market, which has caused rents to rise as demand outstrips supply. In response to poor policies and geographic centric economy issues, property owners may choose to transform their property into a short-term rental or vacation property, resulting in a rise in overall demand.
This situation presents the Federal Reserve with a dilemma: if it cuts interest rates too soon, inflation could reignite, particularly in the housing sector, where demand is still far outpacing supply. However, if the Fed continues to keep rates elevated, it risks worsening the housing crisis by keeping mortgage rates high, further straining renters and potential homebuyers. Federal Reserve Chairman Jerome Powell acknowledged this challenge, stating that while inflation may be moderating, there is still a risk that inflation could flare up again, particularly in sectors like housing. It seems he already knows the issues.
Real Wage Growth: A Misleading Indicator
One of the central issues faced by the Federal Reserve is the disconnect between nominal wage increases and real purchasing power. While the recent rise in wages seems like a positive development, it fails to account for the reality that these gains are being entirely consumed by rising living costs. According to the Bureau of Labor Statistics, real wages adjusted for inflation have barely budged in many sectors. For example, in 2023, the Employment Cost Index (ECI) showed that wage growth stood at about 3.6%, but with inflation eroding much of this gain, the real increase was minimal at best.
The issue becomes even starker when considering housing, healthcare, and energy costs—essential expenses that continue to rise at rates well above the general inflation rate. These disparities make it difficult for American workers to maintain their standard of living. The Economic Policy Institute has highlighted that while higher-income earners have seen substantial wage gains, low- and middle-income workers have largely missed out on these benefits, with their wage increases being outpaced by inflation in essential goods.
The Fed’s Tightrope: Cutting Rates Without Inflaming Inflation
As the Federal Open Market Committee (FOMC) prepares for its upcoming meeting, set for September 17-18, 2024, it faces a critical decision. The Fed has kept the federal funds rate between 5.25% to 5.50% since July, pausing its aggressive rate hikes in response to moderating inflation.
However, with the labor market showing signs of cooling and inflation gradually receding, there is mounting pressure for the Fed to cut rates. The question now is whether a quarter-point rate cut, which markets are expecting, will be enough to sustain economic growth without allowing inflation to flare up again.
The Fed’s dilemma is compounded because its dual mandate—achieving maximum employment and stable prices—is increasingly at odds. The labor market, which has remained strong throughout much of the Fed’s rate-hiking cycle, is now showing signs of weakness. Unemployment remains low but has recently jumped significantly when compared to the last 12 months, but job growth has slowed, and wage increases are being consumed by inflation.
Cutting rates too soon could undermine the Fed’s efforts to control inflation, but keeping rates elevated for too long could push the economy into a recession.
The housing market, in particular, poses a significant risk. With shelter costs making up much of the CPI, any resurgence in housing inflation could have ripple effects throughout the economy. Even with the current interest rate levels, housing prices have continued to rise, driven by a lack of supply and high demand. A rate cut could lower mortgage rates, spurring demand further and driving prices higher, ultimately counteracting the Fed’s efforts to bring inflation under control.
The Limits of Monetary Policy
The Fed’s ability to manage these competing pressures is limited by the tools at its disposal. While rate hikes can cool inflation by making borrowing more expensive, they do little to address the structural issues in the housing market, such as supply shortages and zoning regulations that limit new construction. The Fed’s actions cannot directly impact wage growth, which is driven by broader labor market dynamics and productivity gains.
This reality underscores a broader issue in economic policy: the limits of monetary intervention. While the Fed can influence inflation and borrowing costs, it cannot solve the housing crisis on its own. Without significant changes to housing policy, including measures to increase supply and reduce barriers to homebuilding, the housing market will remain a key source of inflationary pressure, regardless of the Fed’s actions.
A Complex Balancing Act
As the Federal Reserve prepares to make its next move, it faces a complex balancing act. On one hand, inflation is moderating, and there are growing calls for the Fed to cut rates in order to support the economy. On the other hand, core inflation remains elevated, particularly in housing, and cutting rates too soon could reignite inflationary pressures. For millions of American households, wage gains are being eroded by rising living costs, leaving them no better off than they were before.
The Fed must carefully weigh these competing pressures as it navigates the path forward. While it may be tempting to cut rates in response to the recent moderation in inflation, the risks of doing so are significant. The housing crisis remains unresolved, and wage growth, while positive, is not enough to keep up with rising prices. The decisions made at the Fed’s upcoming meeting will have far-reaching consequences for the economy, as it tries to strike a delicate balance between controlling inflation and supporting growth.
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