The housing market downturn is about more than interest rates

For prospective homebuyers, I've got good news and bad news. The good news is that rising interest rates are bringing down home values. The bad news is that rising interest rates mean you probably still can't afford to buy a home.

Mortgage originations, as measured by total value, fell by almost half from the second quarter of 2021 to the second quarter of 2022, and are projected to fall still further through the end of the year. There's no real debate about why that is — the biggest difference in the housing marketplace between last year and this year is that mortgage rates have gone from roughly 3.14% a year ago to 6.94% today. That makes it more expensive for borrowers to get mortgages, it makes it harder for originators to offer mortgages that are either profitable or qualified for acquisition by Fannie Mae and Freddie Mac (or both) and it means those best poised to buy from the increasingly limited single-family housing supply are investors. 

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There is now a lively debate going on in Fed land about whether the downturn in the housing market could or should serve as a warning to the Fed that it may be overcorrecting on inflation. I don't really have a dog in that fight — obviously I would prefer that we do not go into a recession, but if the economy has to take its medicine to get inflation under control, that's a price we should be willing to pay. As we learned from the 1970s, inflation tends not to respond well to half-measures, and it's exceedingly difficult to know for sure what's a half-measure and what's overkill ahead of time. 

With that being said, there is a sound argument to be made that housing is a leading indicator of what rising interest rates have in store for the broader economy. Mortgages and home values are intimately tied to interest rates, and if fewer people are buying homes, fewer people are buying other things that go into homes, like appliances, and there is less support for secondary industries like contracting and home improvement supplies.

But what is curious to me is that whereas prospective first-time homebuyers were shut out of the market a year ago because the market was hot, values were high and supply was low, now they're shut out because the cost of borrowing is high and supply is still low. The end result is the same, and unless the government starts thinking outside of the box it's going to stay the same no matter what happens with the business cycle. 

The way to make that dynamic fundamentally different is to increase the supply of affordable housing, and I will be the first to acknowledge that this is easier said than done. The Federal Housing Finance Agency on Monday announced that it was waiving certain upfront fees for affordable housing products and was transitioning Fannie and Freddie away from traditional FICO scoring toward a more updated credit scoring model. California has embarked on an ambitious goal of increasing housing supply by limiting single-family zoning, paving the way to denser development. 

Will tumult in the housing market change the Fed's trajectory?

But these initiatives are poking around the edges of a more fundamental problem, which is that for a home to exist it has to be both a place for people to live and a sound investment, and ironically a low housing supply serves the latter purpose at the expense of the former. The way to get around that is some kind of federal subsidy, and many people have put a lot of thought into how such a subsidy could achieve maximum bang per buck. I have a personal fondness for extolling the virtues of rehabilitating vacant housing, but here again I'll leave the details to people smarter than myself.

Fed Chair Jerome Powell has said repeatedly that until inflation is brought to heel, nothing else in the economy will work the way it's supposed to. Price stability is half of the Federal Open Market Committee's explicit mandate, and for better or worse that's the ball it has its eye on. Whether housing should be a part of that calculation or not is up to the committee, but let's not pretend that the housing market was working as it was intended up until the Fed raised rates. If we want to change that fundamental dynamic and reap the macroeconomic benefits of a home-owning middle class, everyone needs to think bigger.