Canary in the Coal Mine: Rate Hikes and Housing

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A dose of reality can have a major impact on the thinking of policy makers. Waller was ahead of his colleagues at the Fed in arguing for more aggressive rate hikes and reductions in the Fed’s bloated balance sheet. His own experience with the sizzling housing market no doubt reinforced those views. He sold his home in St. Louis to an all-cash buyer with no inspection only to discover he couldn’t find a home once he got to Washington.

Table 1

Housing outlook

“Trust me, I know it is red hot because I am trying to buy a house here in Washington and the market is crazy.” —   Christopher Waller,
Federal Reserve Governor,
March 24, 2022
All-cash buyers, who are less sensitive to rate hikes, continue to snap up properties, while first-time buyers are losing ground. Sales to first-time buyers dropped at a double-digit rate from a year ago in March.

The collapse in first-time buyer demand is the proverbial “canary in the coal mine,” given the pent-up demand unleashed by low rates and the desire for space during the pandemic. Millennials, who were set back by the housing bust, have aged into their prime home buying years; the spike in both interest rates and home values is crowding them out of the market.

If households can’t buy, they must rent. Hence, the influx of investors snapping up properties to flip to rent instead of buy. This is adding to the shortfall of homes triggered by underbuilding in the wake of the housing bust.

Growth Stalls
Real GDP growth contracted at a 1.4% pace in the first quarter. Domestic demand - consumption, housing and business investment - actually accelerated. Supply chain problems slowed the accumulation of inventories, government spending contracted and the trade deficit exploded. Imports surged, while exports plummeted at their fastest pace since the onset of the pandemic. The war in Ukraine and lockdowns in China were harder on growth abroad than at home.

The economy is poised to rebound modestly in the first quarter but headwinds to domestic demand are building. Consumers are expected to focus more on services than goods purchases and the pace of spending is expected to slow. Housing and business investment are expected to contract with a rise in rates. Supply chain disruptions are another hurdle, as they will limit the ability of firms to restock and invest. Government spending is one of the few positives. Congress finally passed a fiscal 2022 budget six months after the last budget lapsed, which now has to be spent.

Prospects for the second half of the year are worse on the domestic front. Consumer spending is expected to stall. Home buying and building should further contract in response to further increases in mortgage rates. Business investments will likely fall further, while supply chain problems continue to muck up the restocking of inventories. Government spending will hold up better, with gains at the state and local levels finally kicking in; they amassed a boat load of cash during the pandemic and are beginning to spend it. The trade deficit is expected to essentially move sideways, as growth at home and abroad softens. Real GDP is forecast to grow less than 1% in the second half: unemployment is expected to rise.

Why do we care?
  • A loss in the stock of lower priced properties is limiting home ownership and exacerbating wealth inequalities.
  • Renters are unable to fix their monthly payments and hedge against a surge in inflation, especially in a low-vacancy environment.
  • Renters tend to invest less in their homes and communities than owners; over time, that erodes home values and triggers a more destructive cycle of rentals and obstacles to wealth accumulation.
  • Home values are at risk for correcting, given the rapid deterioration in affordability.

Chart 1

Drivers of Affordability

This edition of Economic Currents takes a closer look at the outlook for housing. An influx of investors with deep pockets and excessively tight inventories is expected to blunt but not reverse the blow of a spike in rates.

The Fed is now serious about fighting inflation but a bit late on pulling the punch bowl from the party. A hangover is likely. The housing market will feel the pain first. Hopes that the Fed gradually turns down the music, while we are all still dancing, are fanciful.

A Housing Correction Table 1 lays out the housing market outlook for 2022:

  • Home sales are expected to drop 9% to 6.3 million units. Single-family existing homes are expected to bear the brunt of those losses.
  • Housing starts are forecast to fall 2.2% to 1.57 million but remain well above the 1.4 million pace of 2019.
  • Home values are expected to cool from a double digit to a single digit pace. Some markets will suffer declines.

We are much better positioned to weather a correction in housing than we were during the housing bubble of the early 2000s. That doesn’t mean that rate hikes and a housing market correction will not be painful.

Those who are last in will feel the most pain; that includes speculators hoping to cash in on an endless cycle of rent hikes. There is a gross mismatch between the cost of shelter being supplied and that which is needed.

Downside Risks. Rapid rate hikes, as we have seen in mortgage rates, coupled with the unknown impact associated with the Federal Reserve’s balance sheet reductions, up the risk of a more rapid and deeper correction in housing. Acute shortages are not expected to be quickly rectified but more people will be forced to live together; some could lose shelter entirely.

Deteriorating Fundamentals Buying a home is often the largest purchase a household will ever make; it represents shelter and an investment. The wealth generated by home ownership pays for college and can provide seed money for new business formation. It is a life-altering decision which requires an ability and a willingness to buy. Both are deteriorating:

  • Inflation-adjusted disposable incomes have fallen in seven of the last eight months in response to a lapse in pandemic aid and escalating inflation.
  • Mortgage rates jumped from a low of 2.7% at the start of 2021 to 5.3% by the start of May and are poised to move higher.

Chart 2

Home price growth will cool

  • Affordability is eroding; rising rates are compounding the deterioration from surging prices. (See Chart 1).
  • Those who believe it is a good time to buy plummeted to 30% in a recent Gallup poll, the lowest level on record. The data dates back to 1978 and includes double-digit mortgage rates during two Volcker recessions.
  • The downdraft in financial markets will cool the demand for second homes.
  • Much of the migration triggered by the pandemic has already occurred; this should slow the surge in activity, especially in what were the hottest markets.

The last point is important. Work-from-home doesn’t equate to work-from-anywhere for most workers. The push to get workers to reconnect, innovate and engage boosts productivity and enables our ability to sustain wage gains.

Construction more Resilient than Sales Housing starts are expected to drop 2% to 1.57 million units in 2022. All of that weakness is expected to occur in the single-family market; multifamily starts are expected to continue to post strong gains. Single-family construction is expected to fall to one million units, down 5% from 2021 in 2022 but still above the suppressed levels we saw in 2019.

Chart 3

Mortgage rates rising at record pace

Home builder sentiment, which focuses on the single-family market, fell to the lowest level since the summer of 2021 in April. Large backlogs are expected to blunt the blow to starts; the picture becomes more grim in 2023.

Multifamily starts are expected to jump nearly 6% to 500,000 in 2022, the strongest pace since 1986. Record-low apartment vacancies, a pivot from buying to renting and an influx of investors with deep pockets hoping to cash in on the rental boom will drive those gains.

Builders are on the front line of supply chain problems, both nationally and internationally. The shortages we face are not just about computer chips. Try waiting for a custom-made door or window.

Housing construction has been trailing population growth and household formation for the past decade. Entry-level home and apartment construction have been on a multi-decade decline.

Widespread consolidation of builders in the wake of the housing bust, a loss of workers to other industries and retirement, and strict zoning and regulations pushed developers to build fewer, more expensive dwellings. The shortages of workers and materials triggered by the crisis added insult to injury.

Chart 4

Red hot housing markets

The demand for housing entering the crisis was running about 2.5 million above the supply of homes for sale. That shortfall in supply jumped to an estimated 3.8 million units during the frenzy in 2021.

Persistent housing shortages mean that more people will be occupying the same space to make ends meet. Homelessness, which was on the rise ahead of the pandemic, will rise; inequality will worsen.

A lack of affordable housing will also impact where employers decide to relocate, which is often driven by pricing. Much of the advantage of tax havens is being eroded by an escalation of other costs; private school tuition is included in those figures. Some of the hottest markets experienced the most inflation.

Home Sales Plummet Home sales are expected to fall by 9% to 6.3 million in 2022. Single-family home sales are expected to be hit harder than condos and townhomes.

Existing home sales are forecast to drop 10% to 5.5 million in 2022; new home sales are forecast to hold at 770,000 in 2022, close to the level of 2021.

Existing sales have already begun to roll over with the drop in first-time buyer demand. A drop in mortgage applications for purchases suggest much more pronounced declines in the second and third quarters; applications fell to the lows of 2018, when the Fed last raised rates, in recent weeks. By year-end, existing sales could drop more than 20% from December 2021.

New sales tend to lead existing sales because they are counted when the offer is issued instead of at closing. New sales continued to power ahead even as existing sales dropped.

That is less a sign of resilience and more due to the backlog of pre-sold homes builders have on their balance sheets and an influx of cash investors. Some large builders have joined the speculative game, holding back properties to rent instead of sell.

That was common in the wake of the housing bust to keep homes occupied. My former brother-in-law worked at a company that did this. Renters stripped the homes of all appliances when they left; one took the kitchen sink to get the granite counter top. It is more costly to scale the management of houses than apartments.

Housing Prices Cool Home values are expected to cool to a 5-6% range in 2022, depending on the measure, from a double-digit pace in 2021. Some of the hottest markets of 2021 could actually decline. Prices are more vulnerable in 2023.

Home values were still accelerating at the start of the year. Median new prices, median existing prices and the S&P CoreLogic Case-Shiller index all surged at double-digit rates in the first quarter. The rise in the S&P CoreLogic Case-Shiller index is particularly notable, as it more closely tracks resale values.

The pandemic-induced surge in home values now dwarfs the bubble that we saw during the early 2000s. Year-on-year comparisons become more difficult as we move into the second quarter; that is when home values accelerated more broadly a year ago. (See Chart 2.)

Rapid shifts in mortgage rates are more destabilizing for home values than slow shifts. The 30-year contract mortgage rate jumped from 3.1% in December to 5.3% by the start of May according to Freddie Mac.

The fact that we are starting from such a low level actually amplifies the shock in terms of the incremental impact on interest expense. The percentage increase we have seen in mortgage rates is already the fastest on record. (See Chart 3.)

The good news is that a housing price drop will not trigger a repeat of the crisis of 2008-09. (Albeit, that is a very low benchmark.) Lending standards have improved considerably, while skyrocketing home values fueled a $6 trillion rise in the equity held in homes; that is an extraordinary cushion for home values, should they fall.

Even those who have fallen behind on their loans have been able to sell into a strong housing market. This was true regardless of the condition of their homes. The stock of homes for sale is expected to remain low.

Regional Price Disparities Markets labeled as “second-tier cities” were the main destinations for those who sought to flee major cities at the start of the pandemic. Atlanta, Boise, Charlotte, Raleigh, Phoenix, Tampa and Sacramento are just a few examples. Home prices skyrocketed, pushing many local buyers out of the market.

Those trends are primed to reverse, with some of the hottest markets poised to cool in the year ahead. Some markets will suffer a drop in prices.

CoreLogic found that 65% of the country’s regional housing markets were overvalued in 2022. All markets in red are at risk for cooling. Those most overvalued include all the major markets in Arizona, Florida, Nevada and Texas. (See Chart 4.)

The top five most primed for a drop? Kingman and Prescott, AZ; Stamford, CT; Silverdale, WA and Honolulu, HI. Those represent the tip of the iceberg.

Large urban centers, which were left behind by the pandemic, are recovering some of the population they lost. The hybrid-work genie can’t be put back into the bottle but some return to offices is occurring and likely to accelerate as the pandemic morphs into an endemic.

New York and Chicago are already seeing students and workers return. New York is expected to see its population return to pre-pandemic levels by early 2023.

A Floor on Inflation Changes in rents and housing prices take at least a year to show up in the broader inflation measures. This means that the acceleration in rents and home values we saw in the first quarter will still be exerting upward pressure on shelter costs well into the start of 2023. Those increases are expected to partially offset the drag that goods prices place on overall inflation measures later this year.

In response, core measures of the personal consumer expenditures (PCE) price index are expected to slow from a 5.2% annual increase in the first quarter to slightly above 4% in the fourth quarter. That is still more than double the Federal Reserve’s target of 2% inflation.

The Fed focuses on core PCE because it strips out food and energy costs, which it has less power to influence. Over time, the core PCE also tends to be a better predictor of where overall inflation is going.

A Volcker-esque Fed The Federal Reserve was in a tough position going into its May meeting. It could risk a more prolonged and entrenched inflation with slower, more measured rate hikes or more forcefully slow demand to meet supply constraints. It has chosen the latter.

Fed Chairman Jay Powell is now targeting the labor market to cool overall inflation pressures. Powell said that there is a path to achieving that outcome without triggering a rise in the unemployment rate, but that getting there would be “challenging.” (That is a gross understatement.)

Powell would like to see job openings fall from the record-breaking 1.9 per worker in March to one-to-one. That is closer to where we were before the onset of the crisis. There is no easy way to get from here to there without hammering demand and increasing the supply of workers via a rise in unemployment.

Data released after the Fed met regarding the impact the labor market is having on inflation is even more worrisome. Unit labor costs surged 11.3% from a year ago in the first quarter, well above the overall pace of inflation and the fastest pace since 1982.

A shortfall in investment, record quit rates and ongoing COVID-related staffing shortages is eroding productivity. Productivity growth plunged at its fastest pace since 1947 in the first quarter. That added to cost pressures.

This is what keeps members of the Federal Reserve up at night. We can’t achieve meaningful improvements in living standards if inflation is eroding the gains workers are achieving. We need more balanced growth that enables workers to get ahead of inflation, not chase it.

Our analysis suggests that unemployment has to rise above 5% for inflation to cool to the Fed’s 2% target. The Fed has already started to raise rates and plans to reduce its balance sheet nearly twice as fast as it did in 2018. We expect the fed funds rate to peak at 3.5%.

What would stop the Fed? An external blow to demand and/or a seizure in credit markets. Both would likely be harder to recover from than a Fed-induced slowdown. The latter can be more quickly reversed once inflation has cooled.

Bottom Line We still expect economic growth to stall or worse as the Fed raises rates. The luxury of a soft landing is rapidly becoming more of a stretch; the unemployment rate is expected to rise.

The housing market was among the largest winners from ultra low rates; it is now among the most vulnerable to a correction with rates rising. Not surprisingly, markets that saw the greatest in-migration and housing appreciation during the pandemic experienced the hottest inflation. Cooling those markets is key to taming inflation.

The speed at which mortgage rates go up is already cracking the foundation of the housing market. The worst of the losses are expected to hit in 2023, unless the Fed decides to empty out the dance floor sooner. The canary is still singing but its song is growing more faint.

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