Why Has the Current Federal Reserve Tightening Cycle Been So Tough on Existing Home Sales?

Former JPMorgan Chase Global Chief Economist & Current BrightQuery Chief Economist (Ph.D. in Economics)

Several factors have worked in unison to suppress U.S. housing activity.   The weakness can be seen by observing that Existing Single-Family Home Sales (September 2023) have plunged to their lowest levels since 2010. 

Source: National Association of Realtors and The Federal Reserve of St. Louis (FRED) database

From the start of the latest rate hiking cycle, in March 2022 (using the prior month as a base), single-family existing home sales have dropped by -31.7 percent compared to an average decline of -6.9 percent in previous tightening cycles from 1994-2019.    This decline will be worse if we get another rate hike and need to push our end-of-cycle date to the end of the year, as housing activity has weakened further since the July 2023 rate hike.  At the time of this writing, financial markets are assigning a 24.6% probability that the Fed will raise rates at their December 13, 2023 policy meeting!

Source: National Association of Realtors and The Federal Reserve of St. Louis (FRED) database

Lethal Cocktail: Low Affordability and Sparse Inventory  

A plunge in the Home Affordability Index to levels not seen since the mid-1980s and below-average housing inventory levels have sharply suppressed housing activity. During a monetary tightening cycle, this deleterious cocktail led by rising mortgage rates has been more extensive than anything observed over the past three decades!  Interestingly, the latest Fed rate hikes exceeded those before the GFC (Global Financial Crisis 2007-2009).  After that tightening cycle ended, the housing sector suffered one of its worst price declines since 1929, when the economy suffered the  Great Depression, causing housing prices to decline by 50% in some areas like New York City. 

Source: The Federal Reserve of St. Louis (FRED) database

Why Policy Rate Hikes Are Just Part of the Story

The impact of the Fed’s latest policy rate hiking cycle was a game-changing event for the U.S. housing sector.  The 331-basis point mortgage rate increase was more than four times greater than the average 75-basis points increase during prior monetary tightening cycles, which priced many buyers out of the market. 

The surge in mortgage rates occurred as a larger share of the Federal Reserve’s federal funds rate increases translated into higher U.S. mortgage rates.  Instead of an average 26.6% pass-through to U.S. mortgage rates, we witnessed an outsized 63% pass-through in the current cycle.  High mortgage rates also reduced housing market activity by discouraging millions of individuals from listing their homes and needing to apply for new mortgages when they purchased their next residence.   One study finds that as many as 61% of outstanding mortgages have interest rates of 4.0% or less compared to current mortgage rates approaching 8.0%.   

Source: Freddie Mac and U.S. Federal Reserve

Widening Mortgage Spread

Term premium effects were observed in the U.S. mortgage market, as the spread between the average 30-year U.S. mortgage rate and the 10-year Treasury yield (which typically narrows during monetary tightening cycles) compressed by less.    One factor that put upward pressure on U.S. 30-year mortgage rates is Quantitative Tightening (QT), which led the Federal Reserve to reduce its holdings of mortgage-backed securities as it moved to unwind much of its previous expansive actions to combat the effects of the global pandemic.   With reduced demand for U.S. mortgage debt, the spread between U.S. mortgage rates and the 10-year Treasury reflected the additional upward pressure on mortgage rates.

Source: Freddie Mac and St. Louis Federal Reserve (FRED) Database  

Why Was the Federal Reserve So Aggressive?

The short answer is that policymakers faced a Hobson’s choice.   They could embark on an aggressive policy strategy to lower inflation or do less, lose market credibility, and suffer a permanently higher inflation outcome that would hurt most of the economy’s stakeholders, as Fed Chair Powell has hinted on many occasions.  The core personal consumption deflator (PCE) measures a typical consumer basket of goods and services, excluding food and energy, and adjusted for behavioral demand changes, rose by 3.7% in September 2023, nearly double its 2.0% inflation target!  Against this backdrop, the central bank was forced to act more aggressively, placing undue pressure on the economy's interest-sensitive sectors (e.g., housing and automobiles).   During prior tightening cycles, the Fed moved to stem rising pricing pressures in an environment where the average yearly core PCE inflation only mildly exceeded its inflation growth target, which permitted less aggressive policy actions.  

Source: The U.S. Bureau of Economic Analysis

Summary and Concluding Thoughts

The U.S. housing market suffered the perfect storm and has taken a severe hit recently as U.S. mortgage rates rose much faster than the Fed policy's rise.   This can be easily observed by looking at the contributions of residential investment to real GDP growth from Q4 2021 to Q3 2022!  

This effect was supported by term premium effects, which pushed mortgage rates higher to reflect increased inflation expectations.    Second, as the Fed moved to gradually reduce its holdings of mortgage debt with its QT strategy, the absorption of that extra supply of mortgages put further upward pressure on rates.   The widening spread between the average 30-year mortgage rate and the 10-year U.S. Treasury yield illustrates this phenomenon.   

Until inflation rates move closer to the Fed’s inflation target of 2.0%, mortgage rates are unlikely to return to their pre-pandemic levels of 3.0% or less!  This is evident by the mixed news on inflation expectations.  The University of Michigan’s Survey Research Center revealed that one-year ahead inflation expectations rose to +4.2% in October 2023 from +3.2% in the prior month, even though five-year ahead inflation expectations remained unchanged at +3.0%.   We are progressing as inflation rates have dropped sharply from their peaks but remain distant from the central bank’s desired destination!