Be careful what you wish for

The residential real estate market has frozen up in recent years. Mortgage rates have risen in response to the Fed’s rate hikes, while home prices themselves have increased as demand outstripped supply. The result has been a crisis of affordability in one of the most critical areas of the economy for the average American. We are often told that inflation would be lower if only the housing component softened. Due to the power of the “wealth effect,” however, whereby strong asset prices spur consumer spending, the Fed has to worry what would happen if housing fell on hard times.

Rates are high

Affordability for housing is at the lowest ever seen in data going back to the 1980s. Affordability is a function of incomes, sales prices and interest rates. The Fed raised rates more than 500 basis points in 2022 and 2023. Even the central bank’s late 2024 cuts of 100 basis points have not really filtered through to mortgage rates. To some extent, of course, this is simply a function of the different terms involved, but something more is at work here. For one thing, 10-year rates have remained high due to fears that tariffs and deficits will make inflation endemic. Furthermore, mortgage rates themselves remain at roughly a 100 basis point higher premium to 10-year Treasurys versus the pre-Covid average.

Supply is low

High mortgage rates have kept supply low. Home sales are currently down to 2008 levels arguably because of the Fed’s own actions. By keeping the fed funds rate at essentially zero for 10 of the 13 years prior to the 2022 rate hiking cycle, homeowners were granted the opportunity to buy or refinance when mortgage rates were at historic lows; as a result the average rate for existing mortgages is now just 4%. This stands in stark contrast to new 30-year mortgages at roughly 7%. The spread between the rates of in-place mortgages and new mortgages is historic—and that causes the famous lock-in, whereby homeowners remain where they are due to sticker shock at the rate they would face if they moved.

Markets don’t stay frozen forever

This is all starting to change. Markets can only stay frozen for so long. Eventually, some previously reluctant sellers will need to move, increasing the supply. There is tremendous unmet need for housing in the US, with economists estimating we are short several million units. That is not quite the same thing as demand, though, for demand is suppressed by the lack of affordability. We are beginning therefore to see prices moderate and in some regional markets decline outright, while inventories rise as sellers face the music to meet demand. With affordability this low, unless rates come down, prices have no choice but to fall. And home equity could decline quite a distance in the worst case: home prices have risen more than 50% since 2019.

The Fed

Chair Jerome Powell acknowledged this week that concerns about inflation in response to new tariffs have prevented the Fed from cutting rates further. With shelter a meaningful component of inflation measures, declining appreciation in housing costs would clearly be beneficial to this risk. But housing price appreciation’s contribution to consumer net worth over the last few years was one of the underappreciated factors preventing the recession that so many prognosticators were calling for. (The Federated Hermes equity group was never in that camp.) And the “wealth effect” works both ways. Euphoric consumers spend more when home prices and equities are up. When they fall, however, household budgets get slashed. The Fed has acknowledged that current rates are restrictive and with the potential for housing to roll over, it has a difficult choice ahead. Is it really willing to break the housing market to hasten inflation’s decline?