With the Fed massively behind the curve on inflation, what happens to home prices next?
Most American homeowners will probably end the recession playing with house money.
O ne of the iron rules of investing in inflationary times is to invest in real assets, because they tend to keep up with inflation. A prime example of a real asset is, of course, real estate. So far, as inflation has skyrocketed, real-estate prices have done what they have always done in the past, kept up. But if inflationary spirals tend to end in recessions, then they also end in collapsing housing markets. If — or when — that comes to pass, how bad will it get?
First, the good news. According to the Case-Shiller U.S. National Home Price Index, housing prices have jumped a whopping 19.8 percent over the past year, so home prices have more than kept up with inflation. And the increases are happening everywhere across the country, with San Diego and Miami posting increases of more than 29 percent relative to a year ago. Even the pockets of the country plagued by “defund the police” movements have seen big upward movements in prices, with San Francisco up 22 percent, and even Chicago up 13.1 percent.
With the Fed massively behind the curve on inflation, and in the midst of engineering what will likely be a historically aggressive monetary contraction, what happens to home prices next?
To be sure, the Fed’s actions are harming the housing market. Take, for example, the 30-year FHA mortgage rate, which was about 4 percent at the beginning of March, but is at almost 6 percent today. In 2020, that same rate was about 3 percent. The interest-rate jump, plus the increase in prices, has reduced housing affordability, and the carnage is beginning to be visible in market activity. For example, the National Association of Homebuilders conducts a sentiment survey of its members. It had steadily declined over the past five months, and then it plummeted in May. New home sales were down 8.5 percent in March, and are likely down much more in April and May.
If you are a home builder or home buyer, these numbers are terrifying. But if you are a current homeowner, focused solely on the price of your own home, then they are not so disturbing. Historically, one of the biggest threats to the value of existing homes is a surge in new construction. When construction booms, the supply of homes skyrockets, and prices of new and old homes fall to clear the market. Because of Covid, there has not been anything like the kind of construction boom that presages a collapse in prices. In 2008, for example, housing inventories climbed so much that there was a twelve months’ supply of homes on the market. Today, the supply of homes would be fully exhausted by six months of sales.
Back in 2008, housing prices did drop sharply to clear the market of all of that excess inventory. The Case-Shiller price posted a peak year-over-year drop of 12.75 percent, while the FHFA index dropped 7.1 percent. In the early ’80s, home prices had so much forward momentum from inflation that they almost escaped Paul Volcker’s attack on inflation. At the worst moment of the 1982 recession, home prices were only down 1.6 percent, even with mortgage rates above 16 percent.
The economics of the near future of the housing market is not as scary as one might think given the large increase in prices and the coming additional tightening of the Fed. New construction will slow sharply, and the downward pressure on the price of existing homes from new supply will moderate sharply as well. Stagflation is a strange thing in the housing market. The low growth wants to push the price down, but the inflation wants to push it up. If history is a guide, then, one shouldn’t panic about the state of the housing market.
For the recession we are probably entering, the most likely outcome is that home prices decline somewhere between the 1982 rate and the rate from 2008. After a 19.8 percent increase over the past year, the odds are that most American homeowners will end the recession playing with house money.