It is often said the Federal Reserve’s policy tools, raising and lowering interest rates and adding or withdrawing liquidity to the financial system, are blunt tools. That is because interest rates and credit conditions generally affect the entire economy, irrespective of what the actual causes of inflation may be, and thereby frequently cause collateral damage. The adage is particularly true in the current cycle because of the conditions in the housing market.

The housing market is particularly important for inflation purposes because the cost of housing makes up over 40% of the calculation the Fed uses to measure inflation. It is really difficult to bring inflation to a heel if housing costs are soaring, as they have in the last several years.

Generally, inflation rises when too many buyers are bidding for more supplies and services than the economy is producing. That can result from there being too many dollars in circulation. But it can also be the result of a structural imbalance between supply and demand. All of the data suggests that the current inflation in the cost of housing is caused by the latter.

After the housing bubble of the early 2000s that led to the subprime crisis in 2008-2009, the construction of new homes plummeted in the U.S., going from a high of nearly 2.3 million in January 2006, to just 478,000 in February 2009, an 81% decline. In the decade after the subprime crisis, housing started to only gradually recover, reaching 1.5 million in December 2019. The recovery was put on hold for a few months early in the pandemic before resuming its upward track until – wait for it – the Fed began raising interest rates in early 2022. Since then, the new starts have gone down every month.

In addition to the financial constrictions on the construction of new homes, there has also been a substantial increase in the difficulty and cost of obtaining permits to develop land and build new homes. A 2019 University of California study found that permitting fees added over $23,000 to the average new house in California. But even more problematic are the delays and uncertainty in the permitting process which discourages investment.

As a result of these factors, for the last decade, far more new households (i.e. family units seeking live together) have been created in the US than new homes. In a study earlier this year, Realtor.com estimated that about 6.5 million more households were created than new homes built in 2012-2022. Even if all new multi-family homes are added, the shortfall is still 2.3 million. In other words, housing prices are not high because of an overheated economy or a bubble as we saw in the subprime debacle. It is the result of a structural shortage resulting from the supply of new homes badly lagging the formation of new households.

So, if we want to get the cost of housing down, we need to increase the supply of housing. But higher interest rates and tight credit conditions do exactly the opposite. Indeed, there are few parts of the economy that are more adversely affected by high interest rates than housing. Not only do higher interest rates discourage the construction of new homes, but they also encourage homeowners with lower interest mortgages to stay put.

As long as the Fed keeps interest rates high, the supply of new homes will continue to be constrained keeping pressure on housing costs, thus working against the Fed’s goal to reduce inflation back to 2%. There has been a fair amount of academic criticism of the methodology the Fed is using to measure housing costs. There are some economists who believe it is not possible to get inflation to back to 2% if the Fed continues to use its current methodology for calculating housing costs.

That math is well above my pay grade. But I talk to enough young people struggling to get into their first home to know that we must do something to make homes more affordable . . . and high interest rates are not going to do that.