As costs of construction labor and materials skyrocket, and home price appreciation slows, it is reasonable to expect some slowing in new home construction, writes Laurie Goodman.
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About the author: Laurie Goodman is an Institute Fellow at the Urban Institute. She founded the Housing Finance Policy Center at Urban in 2013, and was its director or co-director from 2013-2021.
The Federal Reserve is contemplating a decrease in its balance sheet within the next few months, as part of its broader tightening of monetary policy. That policy shift reflects a stronger economy, tight labor conditions, and rising inflation. What will happen to the housing market? As the effect of changes in the Fed’s balance sheet cannot be disentangled from changes in interest rates, we will address both together.
Start with the balance sheet. During the pandemic, the Fed took a page from the playbook developed in the wake of the 2007-2008 financial crisis, and engaged in large-scale asset purchases. In March of 2020, in response to the Covid-19 dislocations, the Fed announced Treasury and mortgage-backed security purchases “in an amount necessary to support smooth functioning of the market.” March and April of 2020 were the Fed’s largest-ever purchase months, much larger than during the last round of large-scale asset purchases in late 2008 through October 2014. As the market stabilized, the Fed slowed its net new purchases of Treasury securities to $80 billion a month and MBS purchases to $40 billion a month. On the mortgage side, these new purchases plus the runoff replacement in a high prepayment environment resulted in MBS purchases of $100-$125 billion per month.
In November 2021, the Fed announced a reduction in net purchases of MBS (and Treasury securities). The wind-down was originally going to take 8 months but became more aggressive as inflation intensified. The Fed will not increase the size of its portfolio after early March, 2022. Market expectations are that, within a few months, the Fed will begin to allow the portfolio to run off by a specific amount each month. This is very different than the wind down from the financial crisis, in which the Fed continued to reinvest the payoffs from MBS for three years (from November 2014 to September 2017), holding its balance sheet roughly constant during that time.
The theory behind the Fed’s balance sheet plans is that large-scale asset purchases complement the Federal Reserve’s open market operations, which target short term interest rates. These asset purchases are particularly important when short-term interest rates are near zero; in those circumstances the Fed cannot reduce rates further. The Fed’s longer-term Treasury and MBS purchases should lead to an increase in the prices of the securities (decreasing their yields). This improves home purchase affordability and refinance economics. It also spurs the economy by incentivizing asset managers to acquire assets with higher yields, such as corporate bonds. On the flip side, when the Fed is raising short term rates, reductions in the size of the balance sheet would amplify this tightening by putting additional upward pressure on longer-term rates.
How will these dynamics affect the housing market? We would expect home-price appreciation, already slowing from its highs, to moderate further. Appreciation during the pandemic reflects dwindling supply, lower rates, as well as some pull-forward of millennial homebuying demand, as the pandemic highlighted their desire for more space in a work-from-home environment.
Housing prices are up 18.5% from the end of 2020 to the end of 2021, and interest rates are increasing. The 10-year Treasury and mortgage rates are up 110 and 125 basis points, respectively, from late 2020 to February 2022. As a result, affordability has worsened; the payment on a 30-year fixed rate mortgage would cost over 39% more for the same home from late 2020 to Feb 2022. (The math: a $300,000 mortgage at a 2.67% rate would suggest a monthly mortgage payment of $1,212. The new home value would be $355,500 given 18.5% home-price appreciation; the current mortgage rate is 3.92%, for a payment of $1681, a 39% increase). We would expect these hefty increases in interest rates to challenge affordability and slow home-price appreciation, despite income gains and a stronger economy. While the rate of home-price appreciation could fall dramatically, it’s hard to envision outright declines in prices given the tight inventory.
We would also expect to see a dramatic decline in refinance activity. With mortgage rates up over 100 basis points, Black Knight data indicates the number of borrowers who would find it economical to refinance to a lower rate has been cut by more than two-thirds since late 2020. However, refinance activity will not disappear. Given the substantial home equity that borrowers have, cash-out refinance activity will likely stay robust.
We do expect existing home sales to decline, as homeowners stay in their homes longer to preserve their low-rate mortgages. Some of these homeowners have outgrown their homes; but in a higher rate environment they may choose to renovate rather than move. In order to fund this renovation activity, we should see an increase in home equity lines of credit and other second-mortgage products.
And in a nonrefinance environment, we would expect credit standards to become a bit looser, particularly on new purchase mortgages. With the refinance wave over, mortgage originators have excess capacity Many will be more willing to approve the marginal borrower—working harder to deal with a new down payment assistance program, to help collect information on an additional income source, or to lend on a home that does not appraise at the negotiated sale price.
Finally, new home sales have been very strong the past few years. Developers have been able to borrow at low rates to fund their construction. With rates up substantially, and developer financing generally tied to Treasury rates, borrowing will become much more expensive. With the costs of raw materials and labor also skyrocketing, and home price appreciation slowing, it is reasonable to expect some slowing in new home construction.
Bottom line: With the Fed expected to wind down its portfolio in the months ahead, we expect higher rates and slower home-price appreciation. We also expect a dramatic decline in refinance activity, some relaxation in credit standards, an increase in financing for home improvement, declining existing home sales, and possibly less new home construction.
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