Seller Stasis: The Fed’s Unintended Effect on Housing

Fed observers often invoke terminology or metaphors involving these officials steering ships or pulling levers, sitting at the helm of America’s giant economy. We have always thought such visions are wrongheaded, overstating central banks’ power. Their interest rate moves, the chief way they affect the economy, often don’t do what they purportedly intend. Now, with all the attention on central banks, it shouldn’t shock you that examples abound. Today, we found one too juicy to ignore: the US housing market.

If the Fed had even an ounce of control, housing is where we would logically expect to see it. Outside the handful of metro areas distorted by all-cash buyers, home demand is credit-sensitive. All else equal, higher mortgage rates should jack up potential monthly payments, curbing demand. This lower demand, all else still equal, reduces prices, removing the incentive to build new homes—hitting construction. That reduces real estate’s economic contribution, slowing GDP growth. Hence, Fed rate hikes that translate to higher mortgage rates should cool residential real estate.

Yet 2023 had other ideas, proving all else is never equal. Average 30-year fixed mortgage rates have climbed alongside Fed rate hikes, spending all of this year above 6.0% and often approaching 7.0%.^[i] Yet home prices, while down relative to very recent history, remain far above pre-pandemic highs. How come? Supply.

It seems high mortgage rates have not only affected some would-be buyers. They dissuaded would-be sellers from moving. Those who locked in mortgages at generational-low rates over the past several years are loath to surrender a mortgage that costs between 3% and 5% for one that costs 7% or more. Incentives matter, and high rates turned out to be an incentive for homeowners to stay put.

As a result, the supply of existing homes for sale remains lower than at any point pre-COVID (Exhibit 1), leaving buyers scrambling for a limited pool of houses—which is creating bidding wars for the new homes on the market, giving builders a fat incentive to get moving.

Exhibit 1: Home Supply Hasn’t Recovered From COVID-Era Lows

Source: FactSet, as of 7/20/2023. Existing homes for sale (months of supply), June 1982 – May 2023.

You can see the fruits of this in May’s 15.7% m/m surge in housing starts.^[ii] June’s tally, out yesterday, eased back from this but single-family starts were still at their second-highest level since June 2022.^[iii] New home construction is the chief way residential real estate shows up in GDP, so it looks like housing is set to flip from a modest economic headwind to a small tailwind—despite mortgage rates being at their highest in decades.

This is but the latest example of the Fed’s long, long history of ignoring the supply side of the economy. They did it throughout the 2010s, presuming quantitative easing (QE) bond purchases would boost loan demand by lowering long-term interest rates—and missing that this would wreck loan supply by distorting banks’ risk-taking incentives. To us, this is a big symptom of the central bank groupthink former BoE head Mervyn King lambasted on a podcast with Bloomberg’s Merryn Somerset Webb this week, which is well worth a listen. As he explained: “It stems from the economic profession, the academic profession, which has generated a large number of very brilliant young economists, but they’ve all been trained to believe the same thing and they’ve all gone to work in central banks. So what is, what is it that they believe that's a mistake?”^[iv]

The mistake he referred to is one we have also discussed at length: forgetting inflation is always and everywhere a monetary phenomenon. But we think it could easily apply to a number of deeply ingrained assumptions that policymakers seemingly haven’t bothered testing against the evidence. That includes a myopic focus on the demand side of the economy, which we think goes hand-in-hand with the philosophical abandonment of Milton Friedman and the monetarists that King was lamenting. Friedman was a leader of the monetarist, supply-side economics movement that went mainstream in the 1980s, but this is passé now.

This isn’t just an academic curiosity. So much of this same groupthink underpins commentary on central banks and what their decisions mean for stocks—which risks leading investors astray if they don’t question the logic. Fisher Investments’ founder and Executive Chairman Ken Fisher wrote in his 2006 book, The Only Three Questions That Count, that fathoming what others find unfathomable is a key part of investing successfully. Fed assumptions are fertile ground for this. So whenever you see a Fed speech or Fed-related commentary that focuses on the impact of their decisions on demand, step back and ask: What about supply? What unintended impact could those Fed moves have? Chances are you will find something the Fed and many others miss.