Charlie Harper: Fed Targets Cost Of Housing, But It’s Not Like 2008
Monday, September 26th, 2022
The Federal Reserve has again hiked short term interest rates by three quarters of one percent. It was the third such move in as many meetings with the projection that rates will increase another full percentage point by the end of the year, a significant upward revision.
The projections released with the announcement of the rate hike also seemed prepared to dispel any notion of cuts in the near future. The Federal Reserve now believes it will be 2025 or later before inflation returns to their target of 2% annually.
More importantly, Chairman Jerome Powell is blunt in warning that there will be “pain” on the path to getting there. Let’s break down what that looks like from here.
Just a few months ago, homes were being sold almost as fast as they were offered, with Realtors reporting multiple offers above asking prices for many listings. The Fed’s goal is to return the demand for housing in line with supply, with normal marketing times and less competitive bidding for each listing.
Why do higher interest rates bring down prices for homes, cars, and other items purchased on credit? It’s because most consumers buy these things based on payment amount, not on purchase price. If the homeowner can afford a $2,000 per month principal and interest payment, they can afford a $475,000 house at a 3% interest rate, but that house would cost them $3,000 per month at a 6.5% interest rate. To stay at a $2,000 payment, they would need to find a house for about $315,000.
The 30-year mortgage rate has hit the same levels achieved in 2008. The Federal Reserve then was trying to burst the speculative bubble in real estate prices. The result was an ensuing crash in prices that bled into the overall financial system.
Unlike 2008, the supply of homes continues to remain under what the market would normally be demanded. You can see how the above payment changes over just a few months would affect demand. Some buyers can no longer afford the homes they wanted in a particular area. Others will just sit and wait, hoping for rates to return to prior levels again.
A fundamental premise here is that markets work on “rational expectations” of both a buyer and seller. When those in charge of interest rates continue to change their projections on a monthly basis, both buyers and sellers become confused as to what to expect next. It takes time for each side to become comfortable with where the market is in the interim period.
While the housing market will likely see some blips in the months ahead, no one should be expecting a 2008 style crash. Again, it’s about the supply side.
Builders haven’t been flooding the market for a decade to speculative buyers hoping to flip their purchase soon to a higher price. Instead, you have homeowners who have likely bought their homes or refinanced into mortgages at 3-4%, with a lucky few even lower. Because of the dramatic price increases over the last two years, homeowners are also sitting on record amounts of home equity.
The result, as is often the case in economics, will be a perverse reaction to what is intended. While the Fed is achieving its goal to tamp down demand, they’re also reducing the supply of housing on the market. It increases the cost to builders who want to supply the market, while also diminishes their appetite for risk to build houses on a speculative basis. Meanwhile homeowners who have locked in cheap 30 year mortgages aren’t as willing to trade up to a similar home that will cost them 50% more on their base mortgage payments.
Thus, a tight housing supply is likely to get even tighter. There should not be a high wave of foreclosures, as those who need to sell should be able to find a buyer rather than give the house – and their equity – back to the lender.
There’s an even bigger problem here. The index used to calculate inflation is heavily weighted on rents and the cost of housing. If the prices don’t decline – or at least stop increasing – it will be virtually impossible for the target of 2% inflation to be reached. The longer high mortgage rates keep individuals from becoming homeowners, the more demand for rental housing will be created, keeping prices high.
It’s ultimately not the price of housing or cars that the Fed will have to target in order to see real price declines. It’s the labor market.
So long as the unemployment rate is near historic lows – with more jobs available than people to fill them – there will remain a strong consumer demand willing to push up prices. For the real “pain” needed to fix the inflation problem, it’s going to have to be found at the unemployment line.
Economics remains the dismal science because it ultimately finds hard truths. Right now, that truth is that you shouldn’t be worried that the Federal Reserve is targeting the value of your home to fix their inflation problem. You should be more worried that they’re going to have to target your job to fix a structural economic problem that they once dismissed as “transitory”.