Housing, the Fed, Interest Rates and Inflation

Housing is a key transmission mechanism for the FOMC

It is important to understand that housing is a key transmission mechanism for Federal Open Market Committee (FOMC) policy. There are several housing related channels according to economist Frederic Mishkin: Housing and the Monetary Transmission Mechanism

By raising or lowering short-term interest rates, monetary policy affects the housing market, and in turn the overall economy, directly or indirectly through at least six channels: through the direct effects of interest rates on (1) the user cost of capital, (2) expectations of future house-price movements, and (3) housing supply; and indirectly through (4) standard wealth effects from house prices, (5) balance sheet, credit-channel effects on consumer spending, and (6) balance sheet, credit-channel effects on housing demand.

So, when the FOMC raises rates, housing is a key target. For example, higher rates change the trade-off between buying and renting, and also changes the calculation for investors. Higher rates have already slowed down the “home ATM” (Mortgage Equity Withdrawal) and will likely impact demand (not yet!).

Today, the FOMC raised the “target range for the federal funds rate to 1/4 to 1/2 percent and anticipates that ongoing increases in the target range will be appropriate.” This isn’t much of a change, but the market is anticipating future rate hikes and the coming reduction in the Fed’s balance sheet. And this has pushed up 30-year fixed rate mortgage to 4.48% today for top tier scenarios. This is up sharply from the low 3% range at the beginning of the year.

Inflation: Transitory or Embedded

A key question is how much inflation is transitory (due to the pandemic and the invasion of Ukraine, and the related impact on supply chains), and how much inflation is embedded. The FOMC cannot end the pandemic or stop the war. But they can slow embedded inflation.

If inflation is mostly transitory, the impact on housing will be minimal.

However, if inflation is embedded, the FOMC will continue to raise rates until housing slows down.

Demographics and the FOMC

Demographics have been a key driver of the recent housing boom (linked post from 2015!). So, a key question is: Will higher rates slow that demand? If inflation is embedded, then the answer is yes - higher rates will slow demand.

There was another period when demographics were highly favorable for housing (the early 1980s with the baby boomers), and high interest rates drove housing into a depression. I’m not forecasting double digit mortgage rates, but rates are already up sharply in percentage terms.

Look at housing starts in the early ‘80s in the following graph. Hopefully most of inflation is transitory and the FOMC will not depress housing like in the early ‘80s!

Predicting the Next Recession

Yesterday, on my blog I wrote: Predicting the Next Recession

I pointed out that “Most of the post-WWII recessions were caused by the Fed tightening monetary policy to slow inflation”. Hopefully we see a “soft landing”. I’m not on recession watch, but the key will be to watch housing.