Monetary policy has caused this bubble, and only monetary policy will cure it.
Monetary policy has caused this bubble, and only monetary policy will cure it.
H ome prices are increasing at the fastest rate that we’ve ever witnessed since we first began collecting data just over five decades ago. The chart below illustrates the annual rate of price increase for the Federal Housing Finance Administration’s quarterly data since 1976.
Low mortgage rates boost home values. The following chart compares the monthly Case-Shiller U.S. National Home Price Index to mortgage rates with the latter inverted such that lower mortgage rates move in the same direction as higher home prices.
With a wobble around the housing crisis, home prices generally have risen as mortgage rates fell. The future direction of mortgage rates, moreover, will largely be affected by Federal Reserve monetary policy.
One of the great misconceptions of the quantitative-easing era of monetary policy is the dubious distinction made by analysts and the Fed itself between its interest-rate policy of targeting rates and its balance-sheet policy of acquiring assets to affect financial markets. In fact, the two are inextricable joined; balance-sheet policy is interest-rate policy. In a 2018 Federal Reserve paper cited by Ben Bernanke, the authors state that “the central bank can effectively use asset programs to influence market interest rates.”
The chart below shows how closely the U.S. Treasury ten-year note yield has followed the path of the Fed’s swollen balance sheet, with Fed assets relative to GDP inverted to align asset growth with yield declines.
The most popular home mortgage — the 30-year term — is closely tied to the Treasury ten-year. While these instruments’ maturities vary substantially, the prevalence of early mortgage repayments renders their effective life comparable. Thus, the Fed balance sheet’s effect on Treasury notes in the chart above is also seen on mortgage rates in the chart below.
The preceding chart includes a forecast for the Fed’s balance sheet through next year based on an eight-month taper beginning in November 2021, as provided in the Fed’s September guidance. Any variance in the taper plan won’t materially affect the asset level in the chart. The previous taper was followed by three years of relatively constant Fed assets, so mortgage rates may be suppressed by the Fed’s balance sheet for years to come. That said, small increases from today’s rates could be possible in late 2022 as a constant Fed balance sheet shrinks relative to growing GDP, thus reducing the suppressing effect.
The housing bubble of the 2000s can offer helpful insight in assessing the current bubble. The key indicator in that downturn was new-home sales that peaked in July 2005, well before the home-price peak a year later. The chart below compares new-home sales to home prices.
As an earlier chart showed a relationship between mortgage rates and home prices, the chart below compares mortgage rates to home sales during the 2002–2008 bubble, once again with rates inverted so higher rates align with falling sales.
From mid 2002 to early 2006, as new-home sales peaked, mortgage rates oscillated between 5.25 to 6.25 percent with seemingly little effect. There was a 0.50 percent jump in rates from September ’05 to November ’05, which preceded the serious decline in sales beginning the following month. The bump in rates in the fall of 2005, however, was no bigger than similar moves in the summer of 2003 and the spring of 2004, both of which had no adverse sales impact. Later mortgage-rate drops starting in 2007 similarly did nothing to reverse declining sales. Mortgage rates may have contributed to the housing bubble peaking but were not the definitive cause.
The level of home prices also led to the 2000s new-home-sales slowdown. While home prices continued to rise after the sales drop-off, they peaked relative to consumer incomes at around the same time. The chart below compares new-home sales with an affordability ratio of Case-Shiller home prices indexed to per capita disposable personal income. A higher ratio of prices to income means homes are less affordable.
The price–income ratio began declining in December 2005, which coincided with the rapid declines in new-home sales. The affordability-ratio’s movement is restrained while sales fall more precipitously. Neither affordability nor mortgage rates can be identified as the sole cause of sales declines, but both factors contributed.
Current home prices are nearing the 2000s housing-bubble level relative to income. As shown in the chart below, these rare heights have not corrected without recession in over 35 years.
As of this July, home prices were 13 percent above average long-term affordability. Should prices continue rising for another year, they will be around the ’05 level — 23 percent above average. Declines in home prices from this level would wipe out equity for the new generation of homebuyers. Home prices took a decade to recover from the 2000s bubble.
New-home sales have declined 25 percent from their recent high in January, a seven-month drop matched in intensity only by the wrenching recessions of the 1970s and 1980s. This may represent the beginning of a buyer’s strike with over two-thirds of consumers believing this to be a bad time to buy a house. As shown in the chart below, this statistic is at its worst level in about 40 years. Then, during the brutal early-1980s recession, homebuyers were concerned with double-digit mortgage rates. Now they are concerned with double-digit price increases.
Based upon past metrics, the January sales peak has the earmark of a cyclical peak, with prices likely to fall within about a year. The steep drop in sales and low level of consumer sentiment have generally occurred only in recessions; the unprecedented nature of the pandemic, however, inspires caution for any comparison with past data. It may be that building supply shortfalls have produced a reversion to an underlying upward trend after the pandemic spurt. If not now at a cyclical sales peak, one may be most likely when mortgage rates begin creeping up, perhaps when the Fed balance sheet flattens in late 2022. Recent mortgage-rate increases driven by higher energy prices and “taper tiff” concerns may also affect home prices. It did not take large mortgage-rate changes to tip the 2008 crisis.
Another financial crisis seems unlikely, although a crude measure of the surplus of bank assets over liabilities is at its lowest ratio to bank assets since 2009. Residential construction is 4.7 percent of the economy, so any slowdown in that sector will significantly set back growth.
The Fed has conducted monetary policy with single-minded focus on recent employment data, especially for disadvantaged minorities. The great obstacle for disadvantaged employees is the “last hired, first fired” syndrome. While the Great Financial Crisis recovery was all too slow thanks to misguided big-government policies, it was steady and continued for more than ten years, which enabled the “last-hired, first fired” to get and keep jobs. (That, in turn, led to record pre-pandemic employment among this group.) The Fed has plenty of latitude to maintain stimulative monetary policy while disinflating bubble values and their attendant stability risks. Monetary policy has caused this bubble, and only monetary policy will cure it. The Fed’s September “taper” announcement may be an indication that they recognize that fact. We must hope it’s not too late. As distinguished late historian Herbert Stein is famous for saying, “if something cannot go on forever, it will stop.” History informs us that current home pricing cannot go on forever.