Since the spring of 2022, the Fed’s federal funds rate target – which is the interest rate banks charge themselves for overnight loans – has risen to 2.5% from 0.25% in February. Fed actions raised interest rates on everything from credit cards to mortgages. Higher mortgage rates are starting to drive prices down, but the price drop will be temporary without the increases in supply that are needed to make housing more affordable.

Average 30- and 15-year mortgage rates are at their highest level since 2009, as seen in the figure below from the American Action Forum’s latest housing chartbook by Thomas Wade. The 30-year rate is almost double what it was in 2021, while the 15-year rate has already more than doubled.

Despite these increases, both rates are still near historic lows and below the 6% to 7% rates that were the norm from 2001 to 2009.

While interest rates may not be high by historical standards, recent increases still cause prices to fall. The Case-Shiller and FHFA house price indexes have started to stabilize, as shown in the two figures below.

Year-over-year price changes for both indexes also declined to 15% for the 20-city composite Case-Shiller index and 16% for the FHFA index. Both were 19% in 2021.

Builder confidence is declining in response to falling prices and slowing price growth. NAHB/Wells Fargo
WFC
The housing market index – created from a survey of builders who assess home sales and expectations – fell to its lowest level since before the pandemic, as shown below.

Weaker demand and builder sentiment are showing in housing starts. The figure below shows that housing starts are slowing in all four regions of the country.

Falling housing starts will reduce the supply of new homes and could slow the decline in house prices as supply adjusts to meet lower demand caused by rising interest rates. While this may be good for current homeowners who will experience smaller declines in short-term equity, it is bad for long-term housing affordability. The country is experiencing a major housing shortage, between 6 and 10 million units, which a drop in housing starts will only exacerbate. The tightness of the housing market is reflected in housing and rental vacancy rates, which are at their lowest level in the past 10 years.

We need more housing of all types in America to make housing more affordable in the long run. It’s disappointing but not surprising that housing starts are falling in response to weaker demand and lower prices.

However, it would be a mistake to blame the Fed for the problems in the housing market. The Fed is doing what is necessary to rein in runaway inflation caused by excessive government spending and its own excessive money creation during the pandemic. All other effects of its interest rate hikes on the economy are of secondary importance.

The main culprit for the mismatch of supply and demand in the housing market is too much government regulation. The federal government has long worked to stimulate housing demand through Fannie Mae’s quasi-government agencies
FNMA
and Freddie Mac and other government programs.

Fannie and Freddie buy mortgages from lenders and enjoy implicit government support. Since lenders know they can easily offload mortgages to Fannie and Freddie, they worry less about long-term default risks and can therefore keep borrowing costs artificially low.

Stimulating demand artificially is bad enough on its own – remember the housing crisis? — but what makes the situation even worse in the context of the housing market is that local governments are simultaneously reducing supply through land use regulations. Across the country, minimum lot sizes, parking requirements, convoluted permitting processes, density requirements and other local regulations limit the number of homes that can be built. When supply restrictions are combined with demand subsidies, the result is higher prices that keep adequate housing out of reach for many low- and middle-income households.

Fed rate hikes are cooling the housing market, and with more hikes to come, we should expect that to continue in the near future. The Fed’s impact, however, is minor compared to the negative effects of current federal and local government housing policies that stimulate demand and restrict supply. The Fed’s actions should not prevent us from making the long-term changes we need to balance the housing market: more supply at the local level and less subsidy at the federal level.

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