Do High Mortgage Rates Kill Home Prices?
January 8, 2010 in 2010 Predictions, Best Of The Storm, Fresh Perspectives by Andrew Jeffery
This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux
Given the widespread expectation for future inflation, and as an extension higher interest rates to combat rising prices, the question above is the most common one we hear from home buyers and real estate investors alike. To try and resolve the issue to completion on this short page would be ambitious, to say the least.
During the inflationary period of the late seventies and early eighties (flip back to pg 5 for a picture of
inflation during this period), mortgage rates climbed to almost 20%. In a world where locking in a rate north of 5% feels like a rip-off, 20% mortgages are a thing of fantasy.
Yet, despite this seemingly gale force headwind, home prices still climbed. While there are number of reasons for this increase (demographic, regulatory, etc), let’s focus on one in particular: Inflation Expectations.
Thumb through speeches written by pointy-headed Fed economists and you’ll find this phrase, “Inflation Expectations” peppered throughout discussions of monetary policy and the fear of rising prices. This is one of the least appreciated, yet most important aspects of effective use of monetary policy to manage inflation.
At the core, all economic decisions reflect participants’ view of the future. Specifically, buyers consider what utility (ie, use) they can receive and whether the price for that utility is fair. Embedded within this decision is some expectation of what can be done with that money in the future: Saved, spent, invested, etc.
When consumers fear rising prices, that a gallon of gas will cost more tomorrow than it does today, they buy the gas today. This pushes future demand forward, increasing aggregate demand and in turn, prices. The cycle continues, and in extreme cases (think Zimbabwe or the Weimar Republic), hyperinflation ensues.
As inflation rises, so too do Inflation Expectations. Consumers deploy capital towards assets they perceive to be a better store of value than the worthless paper in their pockets. They buy gold, they buy oil, they buy real estate. So, even with higher rates, money still flows into housing.
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Prices rose in the 70s because inflation also increased wages. Housing is tied to wages/inflation. This is the reason housing is so overvalued now. That traditional relationship broke down and real estate appreciated substantially faster than incomes/inflation.
We could conceivably see higher interest rates without a corresponding increase in wages since so much excess capacity exists in the economy. With the government requiring massive amounts to fund operations, interest rates will probably move higher unless Americans purchase the vast majority of Treasuries. Right now, the Fed is monetizing the debt and foreigners are buying (at much lower levels than just two years ago).
In this scenario, higher interest rates will decimate housing. Affordability will drop like a rock or prices will. If we get a 2% climb in mortgage rates, not inconceivable at all, housing could drop another 15 or 20%. This is based on affordability alone and ignores the shadow inventory.
We have a ways to go, folks.