The Hot Housing Market Makes the Fed’s Inflation-Fighting Job Even Tougher

(Bloomberg Businessweek) -- Federal Reserve officials are counting on higher mortgage rates to throw cold water on the frenzied housing market as they work to tame the highest inflation in decades. But the market may not cool fast enough.

While rising rates and higher home prices are starting to lock some buyers out and weaken sales, pent up demand for housing, combined with a stark shortage of homes on the market, is still putting upward pressure on prices. A dearth of housing inventory also means that rising rates may not slow homebuilding activity as much as they have in the past.

The Fed, which is raising interest rates to curb inflation, is relying on higher borrowing costs on homes, cars and other big-ticket items to put a damper on demand. Rising home prices boost construction and can lift consumer spending, by making homeowners feel wealthier.

The median selling price of an existing home rose 15% in March from a year earlier, according to the National Association of Realtors.

So if housing remains hot, policymakers may be forced to lift borrowing costs even higher. That would complicate their efforts to ease growth and calm price increases without tipping the economy into a recession.

“They're not going to get the decline in economic activity through housing that they typically get, at least not as quickly as they typically get it,” says Mark Zandi, chief economist for Moody's Analytics. “They may have to press on the brakes even harder.”

Fed Chair Jerome Powell and his colleagues are expected to raise interest rates by 50 basis points on Wednesday and signal they're on track to lift them to around 2.5% by the end of the year. But it's not clear if that'll be enough to tame inflation, which is running at more than three times the Fed's 2% target.

That could make the housing market a barometer of whether the central bank has done enough or needs to go further.

Several Fed officials have pointed to the increase in mortgage rates as a sign that their forward guidance on where rates are heading has already had an impact on housing.

“Mortgage rates have come up,” New York Fed President John Williams said during an interview with Bloomberg Television on April 14, “That's going to help bring down that excess demand for that sector relative to supply.”

The average rate for a 30-year fixed-rate mortgage reached 5.1% for the week ended April 28, up two percentage points from the start of the year, according to Freddie Mac. That translates to an increase of $325 a month for someone buying a $350,000 home with a 20% down payment, according to the agency's mortgage calculator.

Existing home sales, which account for about 90% of the U.S. housing market, fell by 2.7% in March to the lowest level since June 2020, according to NAR. They're expected to fall further as higher borrowing costs work their way through the market.

But demand would typically drop off even more in response to such a steep rise in interest rates—were it not for some pandemic-related factors boosting demand, including interest from people who now work remotely, says Bloomberg economist Eliza Winger. And those weaker sales don't necessarily translate into better conditions for buyers.

“The pendulum might be starting to swing back toward a bit more balance, rather than the most unbalanced sellers' market ever,” says Jeff Tucker, a senior economist for Zillow. “But we've only taken a couple of small steps.”

Determining whether competition among buyers will ease and how home prices will react all comes down to what happens to housing supply, which is hovering near record lows because of supply-chain challenges, soaring materials costs, and difficult hiring conditions. After the bursting of the housing bubble in the last recession, builders have also been hesitant to break new ground, contributing in part to the current lack of supply.

If more homeowners are enticed by rising home prices to list their properties for sale, that may help to cool price growth, Winger said.

But many homeowners who locked in low mortgage rates in the past two years could be reluctant to sell and take on a higher rate for a new home, says Daryl Fairweather, chief economist for Redfin. If sellers and buyers both pull back from the market at similar rates, there may not be a noticeable impact on competition or prices, she says.

Housing inventory is starting to rise as some homes take slightly longer to sell and new ones are built. But the shortage is so large that it could take as long as a year for homebuilding to fill the gap and tilt the market in favor of buyers, assuming there is no new demand, Zandi estimates. That suggests home prices may not fall by much, he says.

“We're behind in terms of building, the pandemic didn't make that better, and so we've got this sort of perfect storm in the housing markets that's just pushed prices up even again,” San Francisco Fed President Mary Daly said during an economics conference in Las Vegas on April 20. “What the rising interest rates will do, in part, is slow that path.”

But just taking any steam out of the housing market may be a victory for the Fed if it means avoiding a housing bubble fueled by further double-digit price increases, says Fairweather. “I think even without prices falling, having prices stabilize is a win for the Fed.” —With Catarina Saraiva

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