Will Demand for Housing Continue to Grow?

R ather than slipping into the recession that many economists had predicted, the economy seems to be gaining momentum. One potential explanation for this might be that today’s economy is less sensitive to interest rates than expected as a result of the interaction between inflation and taxes.

In an echo of the 1970s, interactions between high inflation and the tax code have caused effective mortgage rates for many households to decline despite the Federal Reserve’s intent to bring its policy rate above 5 percent.

Before the pandemic, the median home price was about $320,000, and mortgage rates were roughly 4 percent. Given that household inflation expectations were typically 2.5 percent, the real, after-inflation expected mortgage rate was their difference: 1.5 percent. Annual interest on a typical 30-year mortgage with 20 percent down would have been approximately $9,300, and because the 2017 Tax Cut and Jobs Act raised the standard deduction to $24,000 for a married couple, the family probably wouldn’t bother itemizing its deductions. There was little tax advantage to be gained from the mortgage.

Now, home prices and mortgage rates are significantly higher, roughly $470,000 and 6.5 percent for a 30-year fixed-rate mortgage. Today’s median homebuyer will pay annual interest of about $22,000. Higher payments encourage families to itemize rather than take the standard deduction. Indeed, with the current standard deduction at $27,000, taking the $10,000 state and local tax deduction in addition to the mortgage-interest deduction makes itemizing highly advantageous. There’s now a tax incentive to pay interest.

The federal marginal tax rate for the median homebuyer is 22 percent, but with state and local taxes the combined rate is likely closer to 27 percent. If higher interest payments push taxpayers into itemizing their deductions, the effective mortgage rate is 4.75 percent: much closer to the pre-pandemic nominal rate. However, inflation expectations have also risen and are currently at 4.1 percent. As a result, the real effective mortgage rate faced by homebuyers is only 0.7 percent, well below the pre-pandemic rate of 1.5 percent. Adding misguided plans by the Biden administration to lower the mortgage-insurance premium by 0.3 percent, the real effective rate could potentially be close to zero.

In other words, high inflation and tax incentives have resulted in lower real effective mortgage rates relative to pre-pandemic rates. Since many households are unlikely to perform this arithmetic rigorously or may conceive of the tax advantage as only what they’d save in excess of the standard deduction, it seems unlikely that this will cancel out the entire effect of the increase in mortgage rates. And the 45 percent increase in home prices since the pandemic remains a huge barrier to affordability. Still, the impact of relatively lower real effective mortgage rates is big enough to be economically significant, and it means that pessimism regarding home-buying demand may be overdone.

This same phenomenon occurred in the 1970s, frustrating the Federal Reserve’s attempts to control inflation with rate hikes. Calculations by the late Martin Feldstein showed that despite an increase from 1966 to 1976 in nominal mortgage rates by nearly 3 percent, the real effective rate declined by almost 5 percent. While the Fed believed it had tightened policy, monetary conditions had actually eased significantly. Feldstein argued that by ignoring the distortionary interaction of inflation with the tax system, the Fed poured oil on the fire.

These echoes of the 1970s serve as a warning: The Fed may think it has done enough to kill inflation without really having done so, as its models of sufficiently tight policy don’t typically include tax-code granularity. If economic growth and inflation continue to defy gravity, the Fed and markets may find, yet again, that rates must go even higher than they expected.