How Housing Becomes the Ultimate Verdict for the Fed

Receive free Mortgage updates

We will send you a myFT Daily Summary email gathering the latest Mortgages news every morning.

Good day. Here’s a question: are we behind in the old economic cycle or at the beginning of a new one? There is a growing consensus that we are either heading towards a soft landing or are in the middle of one. But what comes after that? Typically late-cycle phenomena (rising defaults, outperformance of growth stocks) or typically early-cycle phenomena (improving earnings growth, outperformance of value stocks)? Send me your opinion: ethan.wu@ft.com.

House prices only go up

Thirty-year fixed mortgage rates are now above 7 percent and haven’t been this high since 2001. And yet, home prices are rising again:

You are viewing a snapshot of an interactive chart. This is most likely because you are not logged in or JavaScript is disabled in your browser.

This is a remarkable and amazing graph. The fastest increases in mortgage rates in decades led to just seven months of falling home prices. Since February they have started to rise. Last year’s decline has been erased.

The reason is limited supply. More than a decade of very little construction left the United States with a chronic housing shortage. High mortgage rates also create a lock-in effect where no one (least of all Rob Armstrong) wants to part with their fixed 3 percent rate. By some measures, supply is near an all-time low. Taken together, even the pressure that expensive mortgages put on demand is not enough to depress house prices for long. The following table shows the scale. The inventory of existing housing, which constitutes the majority of the housing supply, is scarce:

These dynamics are relatively well known. In a recent note, Bridgewater’s Larry Cofsky, Brandon Rowley and Crawford Crooks go a step further. They argue that the imbalance between supply and demand in the real estate sector could force the Federal Reserve to maintain higher rates for longer. An outline of his argument:

• Tariffs have crushed housing demand. In the first 15 months of this rate-raising cycle, mortgage debt as a proportion of GDP has fallen 3 percent. This is a huge figure and by far the largest decline on record so early in a bull cycle. The previous largest decline occurred in 1999, when mortgage debt/GDP fell 0.5 percent in the first 15 months of rate increases.

• But the huge drop in housing demand has barely affected house prices, due to a shortage of supply.as illustrated by the two graphs above.

• Distressed sales and home construction do not seem likely to boost supply in the near term. With a resilient economy and household balance sheets in good shape, few homeowners should be forced to sell. And construction is progressing too slowly. Cofsky, Rowley and Crooks estimate that supply is 3 to 5 million housing units short of demand. But new construction, about 1.5 million units a year, is barely keeping pace with new household formation, so it won’t solve the shortage. Bridgewater Charts:

  

• Much of the impact of high rates on demand has already been felt. In fact, rapidly rising rates “closed the mortgage borrowing pipeline,” resulting in a small drop in home prices last year. However, that has already happened. Even if rates were to rise further, the natural trickle-down of housing demand from, for example, growing families or divorces puts a floor on prices and activity.

• Cutting rates therefore risks a resurgence of inflation through housing demand. By reopening the mortgage borrowing channel, lower rates would likely lift demand and prices. Given the importance of housing to growth and inflation (remember that rents represent a third of the consumer price index), higher rates for longer “will have to be the mechanism to control housing.”

This diagnosis of the real estate market seems accurate to us. But we are a little skeptical that the link between housing and lower rates is so close, for two reasons.

First, the rate-fixing effect, although powerful, is two-sided. Fixed homeowner rates keep supply out of the market now, but rate cuts would reduce compensation for homeowners. At the margin, that should bring more supply of used homes to the market. The question then becomes: what is the net effect between an increase in demand due to lower mortgage rates and an increase in supply due to a diminished lock-in effect? It’s hard to say before the fact. Kiran Raichura, a real estate economist at Capital Economics, thinks it would be slightly positive for housing prices and activity, but probably not the big rebound Bridgewater expects.

The following table, published earlier this year in the Wall Street Journal, makes the point. Shows how many homeowners are subject to different rate levels. A drop in overall mortgage rates from 7 percent to 6 percent probably wouldn’t matter to someone with a 2 percent mortgage. But it could well influence someone who owns one of the 10 million mortgages by 4 to 5 percent:

Second, the relationship between the housing market and measured inflation is indirect. The CPI measures housing inflation through rents. Over time, higher house prices pass through to rents through the “asset price effect”: as house prices rise, landlords who rent out their property will eventually raise rents to keep them stable. rental income. But in the short term there are reasons for optimism in the rental market, which does not only refer to housing. Apartment construction is in a recordvacancies have increased and rental growth has returned to pre-pandemic rhythm.

All that said, the Bridgewater authors make a strong macroeconomic point. Housing, and all the diverse activity linked to it, has gone from a sectoral slowdown to a modest recovery. Unless the balance between inflation and growth is much lower than we think (possible!), that should boost growth and sustain price pressures. We do not believe this precludes rate cuts. But it will probably stop the Fed from rushing to pull that lever.

a good read

Ideas have consequences..

Podcast without FT coverage

Can’t get enough of Unhedged? Listen to our new podcast, hosted by Ethan Wu and Katie Martin, for a 15-minute dive into the latest market news and financial headlines, twice a week. Catch up on previous editions of the newsletter here.