The Federal Reserve’s relentless attack on inflation is jeopardizing our housing market. The resulting damage is not only having an impact on a critical engine of economic growth but is also, ironically, undermining the war against inflation as well.
Resolving an unusual problem requires an unusual solution. The Fed should immediately reverse course and buy mortgage securities to help moderate consumer mortgage rates. It can keep selling Treasury bonds if it so chooses. This will allow the Fed to raise non-housing interest rates, if necessary, while also allowing the housing market to resume functioning normally again.
As fears of Covid waned and the engines of the economy restarted with a bang, concerns about runaway inflation prompted the Fed to embark on one of the most extreme changes in prevailing interest rates in history. The central bank raised its key federal funds policy interest rate to a level about 22 times what it was previously in less than 18 months. Only during the rapid inflation of the late 1970s, when the Fed under its chairman Paul Volcker raised the effective federal funds rate to nearly 20 percent in 1980, has an increase come even close. (And that Fed only roughly doubled rates, not increased them 22-fold.)
In normal times, higher Treasury rates, which make mortgages more expensive, divert household income to mortgage payments and away from other purchases, dampen home buyer demand and, ultimately, lower home prices. Lower home prices reduce homeowners’ wealth, further lowering their spending. And home purchases are such a powerful component of the overall economy — think of everything a new homeowner might need — that making it harder to buy homes helps cool off the rest of our $27.6 trillion economy.
The problem is, these aren’t normal times. Recently, the average interest cost on a 30-year, fixed-rate mortgage neared 8 percent. Less than two years ago, it was about 3 percent, and most homeowners refinanced then or at earlier lows around 2016. The jump in rates has been so unusually large and came on so unusually fast that many homeowners who may want to move suddenly cannot do so because even downsizing could result in a substantially higher monthly mortgage payment. As a result, the U.S. owner-occupied housing market is now experiencing both a mobility and an inventory crisis.
In September, the pace of existing-home sales fell below four million on an annualized basis to a level unseen since the early 1990s, other than during the Great Recession and the pandemic lockdowns. With so few homes being put on the market for sale, the normal effect of higher interest rates — a gradual reduction in home prices and dampening of associated inflation — is simply not able to happen.
There’s more: When owner-occupied homes aren’t made available for sale, and prices therefore can’t adjust downward, more people are forced to rent. And with more households dumped into the rental market, rental prices rise — which is what they have been doing in recent months, defeating the Fed’s effort to beat inflation.
With residential rent making up approximately 33 percent of total and 42 percent of core Consumer Price Index inflation, excluding volatile food and energy prices, the cost of housing has been driving inflation for nearly all of 2023 (and remains potent regardless of what Tuesday’s Consumer Price Index data for October may suggest). In September, if housing prices had not risen, core inflation for the month would have been zero.
It is an irony that the Fed’s effort to tamp down inflation is causing an increase in core inflation measures. And while the Fed is chasing its own tail, other avenues for controlling inflation have weakened considerably as a result of the unique circumstances surrounding the pandemic.
For example, higher-interest auto loan and consumer credit card rates lowered consumer spending in prior cycles, but unprecedented pandemic-era spikes in personal savings have left Americans somewhat less dependent on credit. Nonresidential fixed investment — investments in plants and equipment by businesses — as a percent of G.D.P. (already low) has failed to collapse as businesses, in a manner similar to that of homeowners, already locked in a ton of cheap financing for long periods when rates were at record lows.
What to do? The “easy” answer offered by many inflation doves is that the Fed should simply back off its target of 2 percent core inflation and declare the battle won. I don’t see this happening in Jerome Powell’s Federal Reserve — it has staked too much on achieving that target to gracefully exit now. This is why I believe the Fed must instead call a halt to, and ultimately reverse, another aspect of its policy in order to bring down the cost of new mortgage debt.
When the world’s financial system was under existential threat in 2008, and when Covid shut everything down and markets were in disarray, the Fed purchased huge amounts of Treasury bonds and government-guaranteed mortgage bonds to help keep interest rates low, which in turn helped strengthen the economy. Economists refer to that as Quantitative Easing, or Q.E.
But as the economy revved up again and inflation took off, the Fed swerved into reverse. In March 2022, it began its program of rapid increases in the federal funds rate. Then in June 2022, it took the additional step of embarking on a Quantitative Tightening, or Q.T., program of reducing its portfolio of maturing Treasury bonds and government-guaranteed mortgage-backed securities. Taking the Fed out of the market as a buyer increased the supply for sale, depressing their price. And when bond prices fall, interest rates rise.
For the housing market, the mortgage-securities element of Q.T. — when combined with federal funds policy — eventually proved a step too far: The mortgage market has reacted to Fed policy by demanding a much bigger return on mortgage-backed bonds and related mortgages (which are always priced higher than Treasuries, reflecting the fact that homeowners always have the option to pay off their loans in full at any time). Thus, the “spread” between the 30-year-mortgage rate and the 10-year U.S. Treasury rate ballooned to between roughly 2.75 percent and 3.10 percent from the 1.5 percent to 2 percent range in which it typically hovers. This shot the cost of mortgages to beyond what potential buyers could bear and shut down the housing market.
What the Fed should be doing right now is ending the mortgage-securities element of Q.T. and reversing course to resume buying such securities until mortgage “spreads” settle back to historical norms. To get rents down, we must restabilize and reopen the owner-occupied-housing market. If there were more affordable mortgages for those seeking to move, there would be a greater inventory of homes for sale, which would moderate housing prices. This would ultimately flow into the rent prices that have been stubbornly rising and could continue to rise if the housing market remains locked up.
I concede that what I am describing is a bit of monetary heresy, because to my knowledge the Fed has never blatantly tapped the gas while it was pumping the brakes. Yes, it’s weird, but was having the world’s economy locked down for months and all of us walking around wearing masks for years not weird?
The pandemic era that we are still living in has not proved to be your run-of-the-mill economic shock. Just as creative fiscal policies were employed in the form of direct stimulus and supplements to address the pandemic’s economic slump, innovative monetary solutions must be applied to address the boom and inflation that followed.
Unfortunately, some of the actions taken by the Fed look increasingly like those of the guy who has painted the floor of his house starting at the door. We need to cut a new door to get out.
Daniel Alpert is the managing partner of Westwood Capital and an adjunct professor and senior fellow at Cornell Law School.
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