With the expectation that the Federal Reserve is on the cusp of raising interest rates, we’re hearing all sorts of predictions about how this will affect the red-hot U.S. housing market, which just registered record-high increases for 2021. Though analysts differ on just how many times the Fed will increase rates — much less how high — the impact on mortgage rates when it does act is a given.
What’s less clear, though, is whether rising rates will undermine the housing market by raising the cost of borrowing. On the face of it, they should. The higher the rate, the bigger the monthly payment — and the less potential homebuyers can afford. Housing prices consequently decline.
There’s a seductive appeal to this argument. In the case of the relationship between interest rates and home prices, though, the old warning on medieval maps holds: Here be dragons. Disentangling the many variables in play in this dynamic should give us pause about predicting the future direction of the housing market.
The literature on the relationship between interest rates and home prices is extensive, complicated and contradictory. There’s a general consensus that cutting rates close to zero can help fuel a housing bubble, but the precise mechanisms and timing of how that plays out is still not fully understood. Nor is it entirely well-established what happens when the Fed — or for that matter, other central banks — hike rates.
Consider, for example, the run-up to the financial crisis in 2008, when house prices went through the roof before crashing. Many accounts of that calamity find some version of original sin in the Fed’s decision to slash rates in the wake of the tech bubble’s collapse in 2000 and the 9/11 terrorist attacks, from a high of approximately 6.6% in 2000 to a low of 2% by 2003. Mortgage rates followed, and everyone piled into the housing market — or so the theory goes.
Except, as Robert Shiller has pointed out, this doesn’t quite describe what happened. As he later observed, “the housing market boom was three times as long as the period of low interest rates.” In fact, it arguably began as early as 1997, and, as Shiller notes, “the housing boom was accelerating when the Fed was increasing interest rates in 1999” (emphasis added).
This doesn’t fit with common sense, much less the economic models which predict that changes in the Fed’s overnight rate (or mortgage rates) will automatically translate into a predictable shift in housing prices. One typical model, for example, predicts that a 1% decline in real interest rates should lead to a spike in home prices in certain cities in the U.S. ranging from 19% to 33%.
Models like this — and much of the current hand-wringing about interest rate — reflect a belief that housing is amenable to conventional asset pricing theory. In other words, there’s an assumption that housing is like any other liquid asset, where fluctuations in borrowing costs translate into immediate price changes.
But housing isn’t like another asset; it’s burdened with considerable transaction costs. That means that prices can be quite slow to respond to changes in interest rates — if they respond at all. They’re “sticky,” though some economists prefer the language of physics, trading stickiness for “inertia.”
Evidence for this comes from a recent study by the Bank of International Settlements that looked at historical data on the relationship between home prices and nominal short-term rates. It found that a 1% decline in nominal short-term rates led to a 5% increase in housing prices.
But it took three years for that to happen. “The empirical relationship between changes in interest rates and real house prices,” the authors observed with considerable understatement, “might therefore not be as straightforward as implied by simple models.”
In other words, it takes time — a long time, even — for these changes to turn up in housing prices. In an elaboration of this point, the BIS researchers found that changes in real (not nominal) short-term rates can continue to reverberate for a full five years.
All this may help explain what happened in the lead-up to the crash of 2008. The lag in the effects of monetary policy may mean, as one study has suggested, that the housing bust was partly due to the delayed effects of Fed hikes that began in 2004. By that account, the interest rate chickens only came home to roost in 2007.
Delayed effects aside, there’s the problem of expectations. Evidence exists that when the Fed delivers a “shock” when it raises or lowers rates, it will have an outsized impact on housing prices. But if everyone expects it to raise rates incrementally in a certain fashion and then it does precisely that — well, there may not be as much of an impact on housing prices.
OK, you might be saying. Forget short-term rates. What about rates for 30-year mortgages? They’re climbing right now and that directly affects borrowing. Surely that bodes ill for housing prices, yes?
This, too, has long been an article of faith. One typical early study that looked at historical data found that this was most definitely the case. When mortgage rates go up, home prices go down. But even here things are far more complex than they might first appear.
First, there’s some evidence that this relationship between mortgage rates and home prices was predictable in precisely the way that we imagine prior to the 1980s. After the deregulation of the mortgage market and the spread of securitization, lenders and homebuyers found they could circumvent many of the obstacles that rising mortgage rates originally posed.
Since that time, the relationship between rising long-term mortgage rates and home prices has become even more complicated, with more recent studies suggesting a tenuous connection. In any case, there’s very little consensus. Some studies find a connection; others, such as one that subjected the phenomena to a battery of statistical scrutiny, concluded that “there is virtually no short-run influence from mortgage rates to housing prices.”
The problem, as a recent summary of the various cross-currents at work noted, lies in the fact that rising mortgage rates often go hand in hand with rising wages, a stronger economy and inflation — all forces that in different ways help undercut the burden of rising borrowing costs.
None of this is to suggest that a surge in short-term or long-term rates is great news for home prices. It’s not. But given the time it will take for the full effects to be felt, never mind the many confounding forces at work, it’s quite possible that the housing market may surprise us once again.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
Read more articles by Stephen Mihm
