By Douglas G. Duncan
Things have been looking up in housing. Sales are rising, starts are strengthening, consumer attitudes are improving and prices are rising. This is in line with our forecast of a better 2015 than 2014. However, housing market participants are a bit nervous about the pending change of Federal Reserve policy and its potential impact on mortgage rates and the performance of their sector of the economy
That is a reasonable view given the evidence from the “taper tantrum” of the second half of 2013, the change it drove in interest rates (up over 100 basis points in 6 months) and the resultant impact on housing in 2014 (down from 2013). We don’t think the expected change in the federal funds target, which we believe will happen in September, will generate a “tightening tantrum” spike in 10-year treasury rates, but it is not out of the question. Despite some pretty significant signals of a September rate increase by the Fed, markets still assign a low probability of that increase in September, which suggests some degree of surprise unless that expectation changes over the next couple of months.
There are some misimpressions about the relationship between interest rates and housing activity. If interest rates are rising because the economy is growing—and real incomes are growing with it—then housing does fine as the rise in income covers the additional payment on the mortgage resulting from higher rates.
This is, in part, behind our thematic description of what we have expected for 2015: “The Economy Drags Housing Upward.” We expected the 3 million jobs produced in 2014 to be paired with rising incomes in 2015, which seems to be occurring. This in turn would increase household formation, which is occurring; which would increase demand for housing, which is occurring. Particularly important has been the rapidly improving employment of 25- to 34-year-olds. Interest rates have risen modestly, but housing is improving.
There are other aspects of the relationship of interest rates to housing. If rates are rising because inflation expectations are rising, households appear to view housing as an intermediate term inflation hedge and housing does fine. If rates are rising because the central bank perceives inflation risks and is acting to slow the economy then employment and incomes slow and the number of homes sold falls, not prices.
Nominal interest rates are not directly related to nominal house prices.
In periods when rates rise rapidly
in a short time period, incomes
can’t adjust and home sales fall,
not prices. This was the sequence
of events in the rapid rate rises
of 1994-1995, 1999-2000 and 2013.
Our expectation is that Fed policymakers are fully aware of this relationship and it is one factor in their thinking, since they comment on the state of housing in each of their post-meeting releases. We believe that they will change policy rates slowly and that, in general, mortgage rates will be low for long as the short rates rise faster than long rates and the yield curve flattens. The Fed is, however, already tightening policy as their purchase of replacement for maturing securities is shortening the duration of their portfolio. This is a reversal of Operation Twist and constitutes tightening.
Considering all these relationships, we think housing will continue improving at least through 2017 in a modestly rising rate environment. Currently the biggest constraint in some markets is the lack of supply. New home construction is still well below what demographics would suggest is normal. It will be a couple of years at least before construction reaches that level and in the meantime sales will continue to rise incrementally and prices will rise as The Economy Drags Housing Upward. For the risk managers reading this, note that we are about at the seven year mark of this expansion. The post-World War II average is around six years and our longest one was 10 years. Just sayin’.
Douglas G. Duncan is SVP and chief economist at Fannie Mae.
