Fed plans to ‘reset’ housing market – increasing likelihood of falling home prices

It’s not just how expensive housing became, but how quickly they got there. It took just 24 months for US home prices to skyrocket a staggering 37%. For comparison, the highest two-year peak that led to the housing collapse in 2008 was 29%.

Going into this spring, the Federal Reserve decided it had seen enough. The central bank quickly raised interest rates, which saw the average 30-year fixed mortgage rate rise to 6% – up from 3.2% at the start of the year. Those higher rates, which priced in many homebuyers, ended the pandemic housing boom. We are now in a sharp downturn, with the Mortgage Bankers Association reporting on Wednesday that Mortgage applications are down 16% year-on-year.

As this shift took place, we heard very little from the Fed. Well, that was until President Jerome Powell addressed reporters on Wednesday.

Here’s what Powell had to say: “We saw [home] prices rising very strongly in the last two years. So that changes now. And rates have gone up. We are well aware that mortgage rates have gone up a lot. And you’re seeing a changing housing market. We are watching to see what will happen. How much will this really affect residential investment? I’m not sure. How much will this affect housing prices? I’m not sure. Obviously, we’re watching this very closely… It’s a very tight market. Therefore, prices may continue to rise for a while, even in a world where rates are on the rise. So it’s a complicated situation and we’ve watched it very carefully. I would say that if you are a home buyer, someone or a young person looking to buy a home, you need a little reset. We need to get back to a place where supply and demand are back together and where inflation is down again and mortgage rates are down again.”

Three things stand out.

1. Powell says buyers “need a little reset

In real estate, the total number of active listings is called an “inventory”. Since 2014, annual inventory levels have been decreasing. This was driven in part by changing household preferences (i.e. staying longer), lower levels of home construction following the 2008 housing crisis, and the start of first-time home buying. But once the pandemic housing boom took off, inventory levels began to fall. In the spring of 2021, the stock hit a 40-year low. This gave homebuyers little choice but to raise house prices.

It’s clear that Powell hopes the housing cooling caused by rising mortgage rates will help lift inventory levels. Powell suggests this will help buyers, the thinking is: when buyers restart their home search, they will find a more friendly market. Higher inventory levels would give buyers more time to decide and reduce the chance of them getting embroiled in a bidding war.

Even before the Fed stepped up its fight against inflation, Logan Mohtashami, chief analyst at HousingWire, was openly rooting for higher mortgage rates as a way to boost inventory levels. According to the National Association of Realtors, the US housing stock rose to 1.03 million in May. But to return to a “normal” housing market, Mohtashami says, the inventory would need to increase to 1.52 million to 1.93 million housing units. Inventory levels across the country (see chart below) are rising rapidly, however, and more than half of regional housing markets still have inventory levels 50% below pre-pandemic levels.

View this interactive chart at Fortune.com

“We need a balance… The housing market is still extremely unhealthy because total US inventory levels are still below 1.52 million,” says Mohtashami.

2. Falling home prices? Powell seems to have suggested that it is possible

Fed Chair Powell raised the hypothetical drop in home prices on Wednesday: “How much will this affect home prices? I’m not sure. Obviously, we’re watching this very carefully. You’d think over time. . supply on the housing market of unfinished houses, and as they come into operation…”

He then turned around and said, “While the supply of finished homes, the stock of finished homes for sale is incredibly low, historically low. It’s still a very tight market and prices could continue to rise for a while, even in a world where rates are on the rise. So it’s a tricky situation and we’re watching it very carefully.”

For a moment it looked like Powell was about to say that house prices would go down. Regardless, Powell hasn’t ruled out falling home prices. That matters. Historically speaking, outside of the Great Depression and after the housing crash of the 2000s, year-over-year declines in home prices almost never happen. But today’s circumstances could lead us to a rare period when home prices actually fall. It is revealing that Powell did not close the door on the possibility of falling home prices and instead said that “we are watching this very carefully.”

Last month, Moody’s Analytics chief economist Mark Zandi said Fortune that high mortgage rates led us to a complete “real estate fix”. In the near future, Zandi expects home price growth over the previous year to drop from 20.6% to 0%. In significantly “overvalued” housing markets, he expects house prices to fall by 5% to 10%. If a recession occurs, Moody’s Analytics said it expects a 5% drop in US home prices and a 15% to 20% drop in significantly “overvalued” housing markets. (Moody’s Analytics determined “overvaluation” by comparing regional home prices to what underlying local economic fundamentals, such as household income, would historically support.)

View this interactive chart at Fortune.com

Why are home prices now susceptible to a decline? It starts with the fact that home prices have separated from the underlying economic fundamentals. Basic economic theory teaches that house price growth and income growth are intertwined, and neither can outpace the other for long. This affordability crisis has only been compounded by rising mortgage rates. In fact, over the past six months, typical new mortgage payments have increased by 52%, according to Zonda, a real estate analytics firm.

Home prices may fall, however, but for that to happen, inventory will likely need to go up much more. Once US inventory levels surpass 2 million units, says Mohtashami, home prices could start to fall nationally on an annual basis.

If the Fed’s “excessive tightening” causes a recession, Ralph McLaughlin, chief economist at Kukun, a real estate data and analytics firm, says inventories could reach levels that allow home prices to fall.

“It looks increasingly likely that we are approaching a sharp inflection point in the market,” says McLaughlin Fortune.

3. Powell explicitly said he would like to see mortgage rates fall

The central bank raised interest rates to stop the pandemic housing boom and contain runaway inflation. Once the Fed gets inflation under control, high mortgage rates may begin to recede.

View this interactive chart at Fortune.com

That said, homebuyers eager for mortgage rate relief may be waiting for a while. Last week, the Consumer Price Index was at 8.6%. The Fed will not stop fighting inflation until the CPI returns to 2%. On Thursday, the Fed made it clear that this struggle could last until 2024.

Hungry for more housing data? Follow me on Twitter at @NewsLambert.

This story was originally featured on Fortune.com

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