It’s not just about how expensive housing became—it’s how fast it got there. It only took 24 months for U.S. home prices to soar a staggering 37%. For comparison, the biggest two-year spike leading into the 2008 housing crash was 29%.
Heading 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 climb to 6%—up from 3.2% at the start of the year. Those higher rates, which have priced out many home shoppers, ultimately ended the pandemic housing boom. Now we’re in a sharp slowdown, with the Mortgage Bankers Association reporting on Wednesday that mortgage applications are down 16% on a year-over-year basis.
As this shift occurred, we heard very little from the Fed. Well, that was until chair Jerome Powell addressed reporters on Wednesday.
Here’s what Powell had to say: “We saw [home] prices moving up very very strongly for the last couple of years. So that changes now. And rates have moved up. We are well aware that mortgage rates have moved up a lot. And you are seeing a changing housing market. We are watching it to see what will happen. How much will it really affect residential investment? Not really sure. How much will it affect housing prices? Not really sure. Obviously, we are watching that quite carefully…It’s a very tight market. So prices might keep going up for a while, even in a world where rates are up. So it’s a complicated situation and we watch it very carefully. I’d say if you are a homebuyer, somebody or a young person looking to buy a home, you need a bit of a reset. We need to get back to a place where supply and demand are back together and where inflation is down low again, and mortgage rates are low again.”
Three things stand out.
1. Powell says homebuyers “need a bit of a reset“
In the housing industry, the total number of active listings is referred to as “inventory.” Since 2014, annual inventory levels have been declining. That was driven partly by shifting household preferences (i.e. staying put longer), lower levels of homebuilding following the 2008 housing crash, and the onset of millennial first-time home buying. But once the pandemic housing boom took off, inventory levels began to nosedive. By spring 2021, inventory hit a 40-year low. That has given homebuyers little choice but to bid up home prices.
It’s clear that Powell hopes the housing cooldown caused by rising mortgage rates will help to push inventory levels up. Powell suggest it’ll help buyers, the thinking being: When shoppers restart their house hunt, they’ll be met with a friendlier market. Higher inventory levels would give buyers more time to decide, and reduce the chance they’ll have to engage in a bidding war.
Even before the Fed ramped up its inflation fight, Logan Mohtashami, lead analyst at HousingWire, was openly rooting for higher mortgage rates as a means to increase inventory levels. According to the National Association of Realtors, U.S. housing inventory inched up to 1.03 million heading into May. But to get back to a “normal” housing market, Mohtashami says, inventory would need to rise to 1.52 million to 1.93 million housing units. Inventory levels nationwide (see chart below) are rising fast, however, and over half of regional housing markets still have inventory levels 50% below pre-pandemic levels.
“We need balance…The housing market is still savagely unhealthy because total inventory levels in America are still below 1.52 million,” Mohtashami says.
2. Falling home prices? Powell seems to have suggested it’s possible
Fed Chair Powell raised the hypothetical of home price drops on Wednesday: “How much will it affect housing prices? Not really sure. Obviously, we are watching that quite carefully. You’d think over time…There is a tremendous amount of supply in the housing market of unfinished homes, and as those come online…”
He then pivoted, and said: “Whereas the supply of finished homes, inventory of finished homes for sale is incredibly low, historically low. It’s still a very tight market, and prices might keep going up for a while, even in a world where rates are up. So it’s a complicated situation and we watch it very carefully.”
For a moment it sounded like Powell was about to say home prices would fall. Regardless, Powell didn’t rule out falling home prices. That matters. Historically speaking, outside of the Great Depression and after the housing crash of the 2000s, year-over-year home price declines almost never happen. But today’s circumstances could lead us into a rare period in which home prices do indeed fall. It’s telling that Powell didn’t close the door on the possibility of home price declines, and instead said “we are watching that quite carefully.”
Last month, Moody’s Analytics chief economist Mark Zandi told Fortune that spiked mortgage rates have pushed us into a full-blown “housing correction.” In the near future, Zandi expects year-over-year home price growth to decline from 20.6% to 0%. In significantly “overvalued” housing markets, he expects 5% to 10% home price declines. If a recession does come, Moody’s Analytics said it expects a 5% decline in U.S. home prices and a 15% to 20% decline in significantly “overvalued” housing markets. (Moody’s Analytics determined “overvaluation” by comparing regional home prices to what local underlying economic fundamentals like household income would historically support).
Why are home prices now susceptible to a decline? It starts with the fact that home prices have become detached from underlying economic fundamentals. Basic economic theory teaches that home price growth and income growth are interwoven, and neither can outrun the other for long. That affordability crunch has only been worsened by soaring mortgage rates. In fact, over the past six months the typical new mortgage payment has spiked 52%, according to Zonda, a real estate analytics company.
Home prices can fall, however, but for it to happen inventory will likely need to rise much higher. Once U.S. inventory levels climb above 2 million units, Mohtashami says, home prices could begin to fall nationally on a year-over-year basis.
If the Fed’s “over-tightening” causes a recession, Ralph McLaughlin, chief economist at Kukun, a real estate data and analytics company, says inventory could reach levels that allow home prices to fall.
“It’s looking increasingly likely we’re approaching a sharp inflection point in the market,” McLaughlin tells Fortune.
3. Powell explicitly said he’d like to see mortgage rates fall
The central bank raised interest rates to both halt the pandemic housing boom and to rein in runaway inflation. Once the Fed has inflation back under control, elevated mortgage rates could begin to recede.
That said, home shoppers eager for mortgage rate relief might be waiting for a while. As of last week, the Consumer Price Index was at 8.6%. The Fed won’t let up on inflation fighting until the CPI returns to 2%. On Thursday, the Fed made it clear this fight could last well into 2024.