Herb Stein famously said that if something cannot go on forever, it will stop. Those buying houses in the belief that today’s rapid rate of home price increases will continue indefinitely might take note of the economist’s adage.
With the Federal Reserve beginning to remove the punchbowl that has juiced the industry’s impressive recent boom, there is every reason to think that today’s housing-market party may soon give way to a nasty housing-market slump.
Fueled by the extraordinarily low-interest rates in response to the pandemic, the market has been booming like it has seldom boomed before. Indeed, over the past two years, house prices have been increasing at close to an extraordinary 20% a year clip.
This surge has taken prices to well above their pre-2006 bust level even in inflation-adjusted terms. That has prompted the Dallas Federal Reserve to caution that home prices have become unhinged from their fundamentals, with people buying homes not so much in a rational manner but for fear of missing out. In particular, the Dallas Fed warns that home prices in relation to incomes are at close to record levels.
Those believing that the boom will continue for the foreseeable future point to an acute shortage. They note that home inventories are at barely two months’ supply versus a more normal six months’ supply. They also point to the favorable demographics supporting the market and the very much better lending standards that characterize it today than those that characterized it in the early 2000s.
While all this might be true, the one thing that the optimists seem to be overlooking is how hawkish the Fed has become in its quest to regain control over inflation, which is running at a 40-year high.
This is inducing the Fed to start raising interest rates in 50-basis-point steps rather than 25. It’s also moving it to start reducing its Treasury bond and mortgage-backed security holdings by not rolling over its holdings at maturity. This represents a major policy change: Instead of flooding the financial markets with $120 billion a month in liquidity as it did in 2021 through bond buying, it is now planning to drain liquidity by $95 billion a month over the next year by running off its holdings.
In response to the Fed’s major shift, long-term interest rates have already risen since the start of this year at their fastest pace since 1994. In particular, the all-important 30-year-mortgage rate has jumped from 3.1% at the start of the year to 5.5%.
This means that the average home buyer using a 30-year mortgage can afford to buy a house worth only around 70% of the price he could have afforded at the year’s start. Little wonder then that we are already seeing a major slowdown in mortgage applications — a poor omen for future house price prospects.
Larry Summers, former President Bill Clinton’s treasury secretary, has correctly noted that there has been no previous occasion when the Fed successfully reduced inflation by as much as it is now trying to do without precipitating an economic recession. Meanwhile, in response to the Fed’s more hawkish policy stance, we have already seen the stock market slump by some 15%.
Should we indeed get a recession and should stock prices stay subdued, we’d have two other ways (in addition to higher interest rates) in which the Fed may cause an abrupt end to the housing-market party.
While all too many pundits are arguing that this time the housing market is different and won’t succumb to Fed tightening, my money is on Herb Stein once again being proved correct: If something can’t go on forever, it will soon stop.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.