Previously published on January 20, 2023 in
By Milton Ezrati, Chief Economist at Vested
With the Federal Reserve committed to raising interest rates still further, the future of the housing market remains problematic.
The higher mortgage rates rise, the less affordable housing will become for the average American. Buying and building will accordingly fall even farther than they already have. In time, however, a counter-trend will likely develop as potential buyers come to appreciate how residential real estate offers them at least a partial hedge against the effects of inflation.
They will accordingly stretch to buy, despite high financing costs.
So far, all the pressure has been on the downside. The Fed’s anti-inflation efforts have driven mortgage rates up to 6.5 to 7 percent at present from about 3 percent early in 2022. Because of this rise in financing costs, affordability, as tracked by the National Association of Realtors (NAR), has accordingly declined some 33 percent over the 12 months through November, the most recent period for which data are available.
Homebuying has followed, falling 15.3 percent over this same time, as has new home construction, with starts of new dwellings falling some 22.4 percent. Not surprisingly, home prices have weakened as well. The NAR’s measure of median home prices is off 10.5 percent from its highs of last June.
This downward pressure will continue. Fed Chairman Jerome Powell has promised to keep raising interest rates for the foreseeable future. Of course, the Fed doesn’t aim to hurt housing. Its concern is the fight against inflation. But the pain to the housing market is an unavoidable byproduct. No one knows how far the Fed will have to go, not even Powell. But he has made clear that the Fed’s current policies will remain in place until he and his advisers are convinced that inflationary forces have abated fundamentally.
That means several more rate increases. To be sure, these future rate boosts will come as less of a shock than last year’s and may be less extreme, so the additional downward pressure on housing will be less intense—but it will still weigh heavily.
All could turn around quickly, of course, if, for some reason, inflationary pressure were suddenly to lift of its own accord—but that’s highly unlikely. History shows conclusively that inflation of the sort that the economy has suffered during the past 12 to 18 months lifts neither easily nor suddenly. Even if in the unlikely event that relief were to arrive quickly, the Fed, to be sure it had done its job, would hold its counter-inflationary stance for a while longer. That means that the rate pressure on housing will remain in place and likely build until the second half of the year at the earliest.
Inflationary concerns will, however, carry something of a counter-trend into the housing market. The longer such concerns last, the more potential homebuyers will realize how home ownership offers an attractive inflation hedge and buy despite elevated mortgage rates. One obvious factor is how owning one’s own home, even if costly, fixes the cost of shelter, a major budget item. Whether they own their property free and clear or have financed it with a fixed-rate mortgage, they will enjoy no increase in their cost of shelter, no small consideration when the price of everything is rising.
But there’s more. History shows that residential real estate values tend to outperform other investments during inflationary times and rise ahead of inflation. That was certainly true during the last great inflation in the 1970s and 1980s. Even though inflation from 1970 to 1990 averaged a horrible 6.2 percent a year and occasionally rose above a 10 percent annual rate, housing values gained 8.7 percent a year on average for the entire 20-year period.
Buyers will increasingly strive to avail themselves of the real estate hedge even as buying becomes less affordable. History shows that rather than give up on securing the inflation hedge; they will simply trade down along the price distribution, purchasing a smaller, less lavish house than they otherwise might have or one in a less desirable location. In this way, they secure the hedge against inflation that ownership provides at a price point that their income can support and do so despite higher financing costs. Commerce Department data shows that such a trading down has already started. A smaller percentage of new purchases are occurring at the high end of the price distribution than in, say, 2020.
It’s doubtful that this effect can overwhelm the downward pressure that rising interest rates will continue to place on buying and building. But the longer inflation persists, the stronger this counter-trend will become and the more it will tend to mitigate the otherwise negative influences on residential real estate.