Back in early February, Minneapolis Fed President Neel Kashkari went on CNBC to make it clear that loosening financial conditions, including mortgage rates which had slipped at the time to 6.09%, could interfere with the Fed’s inflation fight if it saw the economy warm up.
“The [U.S.] housing market is starting to show signs of life again because mortgage rates have come back down,” Kashkari said. “You’re right it [loosening financial conditions] does make our jobs harder to bring the economy into balance. All things being equal, that means we’d have to do more with our other tools.”
In the days following that interview, financial markets tightened back, and the average 30-year fixed mortgage rate shot back up to 6.97% as of Friday, as investors realized that improved economic data means the Federal Reserve will likely hold the federal funds rate higher for longer than previously expected.
Real estate agents and homebuilders had been celebrating a slight improvement in transaction levels spurred by reduced mortgage rates earlier this year, but this rebound in mortgage rates means the U.S. housing market, activity wise, could be in for an extended period of sluggishness.
Already, mortgage purchase applications—a leading indicator for home sales volumes—has started to fall again. Indeed, this week’s seasonally adjusted Mortgage Purchase Application Index came in at the lowest level since 1995.
“After a brief revival in application activity in January when mortgage rates dropped down to 6.2%, there has now been three straight weeks of declines in applications as mortgage rates have jumped 50 basis points over the past month,” wrote Joel Kan, the deputy chief economist at the Mortgage Bankers Association, earlier this week. “Data on inflation, employment, and economic activity have signaled that inflation may not be cooling as quickly as anticipated, which continues to put upward pressure on rates.”
The economic shock from this latest mortgage rate jump means the U.S. housing market slump will continue, and could even deepen, risking pushing the U.S. economy into a recession.
On Tuesday, economists at the Federal Reserve Bank of Dallas warned that “the perils detected in the U.S. and German housing markets pose a vulnerability to the global outlook because of the size of those nations’ economies and significant cross-border financial spillovers.”
Historically speaking, the economic impact from the Fed’s inflation fighting always hits housing first. It goes like this: The central bank begins by applying upward pressure on interest rates. Not long afterwards, home sales sink and homebuilders begin to cut back. That causes demand for both commodities (like lumber) and durable goods (like refrigerators) to fall. Those economic contractions then quickly spread throughout the rest of the economy and, in theory, help to rein in runaway inflation.
The question heading forward is if the housing market can absorb these economic shocks without it spreading throughout the rest of the economy. On one hand, private residential fixed investment (i.e. housing GDP) has already seen a sharp pullback. On the other hand, residential construction employment remains at its cycle peak as builders avoid layoffs as they work the historic backlog they accumulated during the Pandemic Housing Boom.
While spiked mortgage rates have translated into a historic pullback in home sales, it hasn’t translated into a house price crash. Through December, U.S. single-family home prices as measured by the seasonally adjusted Case-Shiller National Home Price Index (see chart above) are down 2.7% from their June 2022 peak. Without seasonal adjustment national home prices are down 4.4%. (Keep in mind, some regional housing markets still haven’t seen a decline.)
“Housing froth has reemerged since 2020, with signs of a pandemic housing boom extending beyond the U.S. to other, mostly advanced, economies. While house-price growth has recently begun to moderate—or, in some countries, to decline—the risk of a deep global housing slide persists,” wrote Dallas Fed economists earlier this week.
Heading forward, Dallas Fed economists expect the U.S. housing market to continue passing through a “modest” home price correction. However, if the Federal Reserve were to get even more aggressive in its inflation fight, it could create a “severe” correction in national home prices.
“While a modest housing correction remains the baseline scenario, the risk that a tighter-than-expected monetary policy may trigger a more severe price correction in Germany and the U.S. cannot be ignored,” wrote Dallas Fed economists earlier this week.
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