Previously published on September 19, 2022 in
By Milton Ezrati, Chief Economist at Vested
There can be little doubt that for as long as the Federal Reserve (Fed) remains committed to its anti-inflation tightening policies, housing – sales, as well as construction and pricing – will continue to suffer from rising mortgage rates. But that is not the whole story. Crosscurrents will enter the housing equation as people come increasingly to see real estate as a way to protect their wealth from inflation’s ill effects on stocks, bonds, and other financial instruments.
So far, most of the pressure has leaned to the negative side of the real estate ledger. Since the Fed began to raise interest rates last March, the average rate on a 30-year fixed-rate mortgage has increased, albeit unevenly, from 2.8% to over 6.0%. Because this move has more than doubled the cost of supporting a mortgage, it is little wonder that buying has suffered. Sales of new homes, as tracked by the Commerce Department, have fallen 39% from highs last January to July, the most recent period for which data are available. Construction has followed. Starts of new homes nationally, have slipped 19% from their highs last February. Home prices, too, have softened. The median price of an existing home sold in the United States fell 2.2%, according to the National Association of Realtors (NAR), from $420,000 in June to $410,600 this past July, the most recent period for which the association offers a figure.
The Fed promises to increase this adverse pressure in coming months. Chairman Jerome Powell, understandably, has refused to say exactly how far and how fast he intends to raise interest rates, but he has committed to continuing such steps for as long as it takes to bring inflation under control. Unless the nation gets very lucky, and the inflation abates on its own, he will have to do a lot more than he has already. Consider that with inflation running at 7-8% and 1-year interest rates at 3-4%, borrowers repay a loan with dollars that have lost considerably more in real buying power than the interest they give the lender. That is hardly doing much to stem the flow of inflation-causing demands for credit.
But even as the Fed’s likely actions raise mortgage costs and accordingly intensify adverse influences on housing, the desire to hedge inflation with real estate will increasingly come into play. People will do what they can to buy, despite the rise in costs, because home ownership, whether outright or supported by a fixed-rate mortgage, will stabilize one important part of household budgets, a great lure in an environment when inflation is raising all other living costs. What is more, real estate will likely rise at least in tandem with the general rate of inflation, making it a more attractive store of wealth than say bonds, which will see their prices fall with each interest rate hike and stocks, which will suffer an adverse valuation calculation from rising interest rates as well as the inevitable uncertainties brought by general price pressures.
These forces certainly prevailed during the last great inflation in the 1970s and 1980s. Between 1970 and 1990, the consumer price index in this country rose 6.2 percent a year on average. Fixed mortgage rates rose from about 7.3 percent in 1970 to over 13 percent by 1985, raising the cost of supporting a mortgage almost 80 percent. For those who owned their houses outright or had their mortgage rates locked in, this meant nothing, but it mattered a lot to prospective buyers. Yet, despite the considerable headwind rising mortgage rates imposed on buying, the median price of a house sold in the United States rose during this time from $23,900 to $125,000 an increase of 8.6 percent a year and a return-on-investment 2.4 percentage points a year in excess of the inflation and better than most any other vehicles available to investors.
Of course, rising mortgage costs during this time constrained buyers seeking the real estate inflation hedge, and they will do so in the present environment. But rather than simply drive people away, history suggests that buyers will likely shift down on the price distribution. The budget constraint imposed by rising financing costs will impel people not to walk away but rather to settle for less of a house in perhaps a less lavish location. This effect is already evident in the Commerce Department data. Last December, when mortgage rates were still low and inflation concerns were just budding, a disproportionate number of sales occurred at the higher end of the price distribution. Though the median home price tracked by the NAR stood at some $360,000, fully one-third of home purchases nationwide occurred at over $500,000. Only 29% of national purchases occurred at prices near the median. With the rise in mortgage rates, a movement down the price distribution has occurred. As of July, some 83% of the purchases occurred at prices closely clustered around the median price.
This incipient pattern will likely become more extreme later this year and into 2023. It could extend for longer in the not unlikely event that inflation persists. Sales at the very top prices will no doubt hold up. Affordability means less to those buying in that range, while these same people have a powerful need to protect wealth from losses in financial markets and from the other ravages of inflation. Others who once could reach because of low mortgage rates will trade down closer toward the median price, while those who always had to buy at the lower end of the price distribution will be forced out of the market. The negative pressures will constrain sales and construction and hold back price gains, but less than might be suggested by a simplistic look at only the cost of financing.