by Calculated Risk on 5/20/2024 10:40:00 AM

From Fed Vice Chair Philip Jefferson: U.S. Economic Outlook and Housing Price Dynamics.  An excerpt on housing:

The Housing Market

The Fed sets policy to promote its dual-mandate objectives of maximum employment and price stability, and employment and inflation depend on conditions in the entire economy. Still, given our gathering today, I thought it would be appropriate to dive a bit deeper into the housing and home finance markets.

As I said earlier, the housing sector is one of the most interest rate–sensitive parts of the economy. We have seen that sensitivity in mortgage rates and mortgage originations. As shown in figure 4, 30-year fixed-rate mortgage rates were close to 3 percent when the federal funds rate was near the zero lower bound in 2020 and 2021. Rates surged in 2022 as the federal funds rate increased. Consistent with the increase in mortgage rates, mortgage origination volume has fallen significantly.

The current restrictive stance of monetary policy has weighed on the housing market. That is helping to bring supply and demand into better balance and put downward pressure on inflation. One aspect of inflation that has gotten a fair amount of attention is housing and rental costs. This is because housing costs make up such a large share of household budgets. To calculate housing services inflation, government statistics don't use home prices because a home is partly an investment. Instead, housing services inflation is computed using monthly rents that capture what tenants pay to rent a house or apartment and what homeowners would, in theory, pay to rent their own home. The way this calculation is derived means changes in market rents—or what a new tenant pays to rent—take a long time to pass through to PCE housing services prices, as shown in figure 5. In this figure, notice that increases in market rents, the blue and red lines, peaked in 2022, and PCE housing services inflation, the black line, lagged market rents and peaked in 2023.

Lags in Housing Services Inflation

The primary reason for this lag is that market rents adjust more quickly to economic conditions than what landlords charge their existing tenants. This lag suggests that the large increase in market rents during the pandemic is still being passed through to existing rents and may keep housing services inflation elevated for a while longer. This observation is important because it is an example of one of the underlying sources of lags with which monetary policy affects inflation.

Another factor affecting pass-through of restrictive monetary policy is that fixed-rate mortgages are common in the U.S. It is often argued that this loan structure dampens the effect of monetary policy. Figure 6 shows that the 30-year fixed mortgage rate is about 7 percent, while the average outstanding mortgage rate is about 4 percent. This lower outstanding mortgage rate is due to households who locked in rates during lower-interest periods, including when the Fed cut the target range for the federal funds rate to near zero shortly after the pandemic took hold. Fixed-rate mortgages do dampen the effect of monetary policy, but, according to recent research, not as much as previously thought.

There is a delay between when mortgage rates go up and when household mortgage payments go up, as shown in figure 7. Board staff research documents that mortgage payments go up over time because many households continue to refinance their mortgage or move. Despite higher rates, households in the U.S. borrowed over $1.5 trillion in new mortgage loans in 2023. These borrowers include first-time homebuyers, existing homeowners moving between homes, and homeowners obtaining cash-out refinances. The payment they owe on that recently obtained mortgage is higher than it would have been had lower rates been maintained, and their consumption may be correspondingly lower. The cumulative effect of a higher interest rate on aggregate mortgage payments grows over time as more new loans are originated at the higher rate. The staff's research documents that, historically, borrowers like these who are not deterred by higher rates are responsible for a little over half of the pass-through of interest rates to mortgage payments.

Conclusion

In closing, let me reiterate why we care about housing. The housing sector is where many households have made, or will make, their largest investment. Therefore, the prices that families pay for that housing can affect their overall well-being. The work you do to make housing accessible is an important part of the economy. The housing sector is also a key part of the transmission mechanism of monetary policy. That is one reason why policymakers will continue to pay close attention to this vital sector.
emphasis added

As Jefferson notes, rents for existing tenants are still increasing, even while new leases are mostly flat year-over-year. A key point is that Fed policy can not change what happened a year or two ago, and that is why we need to look at inflation ex-housing.