The Sooner the Fed Gets Unstuck, the Better
Last week the Fed announced it would once again delay liftoff from its zero interest rate policy. During her press conference, Fed Chair Janet Yellen noted that "[the housing market] remains very depressed."
Has the Fed missed the housing liftoff? July existing home sales were at a seasonally adjusted annual rate of 5.6 million, the highest level since the end of the peak of the housing bubble in December 2006. Home sales are up 23 percent from July 2012 - just before the Fed's announcement of its last round of quantitative easing known as QE3 in September 2012. This strength has been more than fully reflected in the home loan market, a market dominated by FHA, Fannie Mae, Freddie Mac, and other government agencies. The spring home finance market has also been booming. Agency unit home purchase volume in August is up by double digits over the same months in 2013 and 2014. This boom has been influenced by outsized gains for first-time buyers (FTB): up 26 and 20 percent over 2013 and 2014 respectively. In August, FTB accounted for 57 percent of primary owner-occupied home purchase mortgages with a government guarantee - representing healthy increases from both August 2013 and 2014.
Home prices are seeing a second liftoff - inflation adjusted home prices are up 12.5 percent since September 2012. This should come as no surprise. Research as far back as the 1950s has shown that the liberalization of credit terms creates demand pressure that easily becomes capitalized into higher prices, especially when undertaken in a seller's market. This is economics 101, pure and simple.
Housing credit risk has also been increasing. The home price increases already noted have been fueled in part by liberalized credit standards, particularly for first time homebuyers. First-time buyers mortgage risk in August, as measured by AEI's National Mortgage Risk Index, is up 16 percent from August 2013. It is simply not true that first-time buyers face tight credit. If you have a steady job and a credit score in the 25th percentile or better, you can buy a home with little money down. Seventy percent of first-time buyers put a 5 percent or less down payment.
Regarding the state of the housing market, Fed Chair Yellen also added that "housing starts [are] below levels that seem consistent with underlying demographics; especially in an economy that is creating jobs...." Yellen is correct that single family house constructions have been slow to recover: they are now at about 40 percent of the early-2000s numbers. The story is quite different for existing home sales which are running well in excess of early-2000s levels and for starts of rental units which are above the levels of the 2005-2006 and early-2000s periods. Add the fact that traditionally the South has accounted for the bulk of US housing starts - in August 2015, it accounted nationally for 58 percent of new one-unit construction and 53 percent of total new construction. This geographic concentration makes the use of monetary policy to accomplish more housing starts all the more difficult.
This raises the question as to why the Fed appears to be holding out for a stronger new home construction market even though home sales are booming. The answer is that government policy in general is tilted towards new construction because it has an outsized impact on GDP growth. This preference was noted fifty years ago by Ernest Fisher, FHA's first chief economist and long-time observer of US housing policy, who noted in Housing Markets and Congressional Goals: "[with respect to housing policies] the one that enables the builder to contribute to the gross national product and increase his profits, pay more wages to building labor, and buy more building materials from manufacturers and distributors has this far been favored [over existing units]."
The Fed's desire to promote new construction poses yet another problem. As Fed economist Ramsey Wood pointed out in 1946, "[n]ew building takes place when the prices of existing housing are higher than the cost of building new houses which consumers regard as comparable...." A further increase in new construction will require higher real home prices. The combination of an "immensely accommodative monetary policy," loose credit, and an improving job market creates the right mix for a real home price boom. The delay in moving away from a zero interest policy will likely continue this upward push on real home prices. The result will be to move the goalpost further away for many lower income and minority renters desiring to become homeowners.
Since 1975 we have seen three other instances of real home price growth, and each ended with a painful price correction. Monetary policy is a blunt instrument. It is ill-suited for fine tuning asset allocation decisions among existing homes, new homes, and new rental units, much less among regions.
The longer the Fed is stuck on zero, the greater the pricing distortions that will result. The Fed needs to get unstuck - the sooner the better.