Six reasons higher interest rates hurt house prices
Higher interest rates reduce housing demand by causing mortgage applications to decline, reducing loan balances, harming employment, and suppressing wages.
The federal reserve establishes interest rate policy, and for the last six years, the federal reserve held the benchmark federal funds rate to zero to stimulate the economy. Also during the period when interest rates were held at zero percent, the federal reserve applied stimulus through a policy known as quantitative easing, a fancy term for printing money. Quantitative easing and mortgage interest rate stimulus were designed to bail out Wall Street, not benefit Main Street.
Last year the federal reserve decided to taper housing market stimulus. Eventually, they will raise the federal funds rate from zero and attempt to move us back to a normal economy with moderate interest rates and no federal reserve stimulus. Previously, the federal reserve under Ben Bernanke promised to keep a zero percent interest rate until certain benchmarks were met, probably not until late 2015. However, one of Bernanke’s benchmarks, 7% unemployment, was reached last December, so the federal reserve under Janet Yellen struggles to establish new benchmarks.
Nobody knows when the federal reserve will finally raise rates, not even the federal reserve, but since higher rates will hurt house prices, we have six reasons to believe the federal reserve won’t be raising interest rates any time soon.
Six reasons higher interest rates hurt house prices
1. Higher rates equals smaller loans
Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate. If rising mortgage rates results in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both. This isn’t speculation; it’s basic math.
2. Higher rates lowers home purchase demand
Higher mortgage interest rates lead to lower sales or lower prices, but most likely, lower sales. Mortgage rates fell from mid 2010 through early 2013 just to maintain a low level of demand. When interest rates went up, in what was supposedly a strong market recovery, demand immediately dropped off. It’s been declining ever since.
And it isn’t like demand was relatively strong in mid 2010 when it dropped to a 13-year low then stayed there for four years.
And this despite a continually rising US population.
For the last four reasons higher interest rates hurt home prices, we turn to HousingWire.
It has to do with jobs, jobs, jobs and jobs
Federal Reserve Chair Janet Yellen said early Monday that the economy and the job market are still ailing and that they will need “extraordinary” assistance from the central bank in the form of low interest rates “for some time.”
It was three words about short-term interest rate policy that sent out more reassurance for investors than her three words March 19 – “about six months” – which sent markets into a spiral.
After last week’s Federal Open Market Committee meeting, Yellen said that the Fed could start raising short-term rates “about six months” after it completed its ongoing tapering of Treasury and bond purchases, which most expect to be unwound by the fourth quarter of 2014.
Speaking in Chicago Monday, Yellen also justified the change from a specific goalpost – 6.5% unemployment – to a more vague and subjective “quantitative guidance” needed given the slack in the labor market, despite the official unemployment rate now standing at 6.7%.
She gave four reasons why she thinks the employment market is still soft.
1) The large number of part-timers.
One form of evidence for slack is found in other labor market data, beyond the unemployment rate or payrolls, some of which I have touched on already. For example, the 7 million people who are working part time but would like a full-time job. This number is much larger than we would expect at 6.7% unemployment, based on past experience, and the existence of such a large pool of “partly unemployed” workers is a sign that labor conditions are worse than indicated by the unemployment rate. Statistics on job turnover also point to considerable slack in the labor market. Although firms are now laying off fewer workers, they have been reluctant to increase the pace of hiring. Likewise, the number of people who voluntarily quit their jobs is noticeably below levels before the recession; that is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another. It is also a sign that firms may not be recruiting very aggressively to hire workers away from their competitors.
Part-time workers generally don’t qualify to buy homes. They either don’t make enough money, or their income is considered too unstable to qualify. Optimists will see this as pent-up demand, but it will remain pent-up as until these workers find high-paying full-time jobs.
2) Stagnant wages
A second form of evidence for slack is that the decline in unemployment has not helped raise wages for workers as in past recoveries. Workers in a slack market have little leverage to demand raises. Labor compensation has increased an average of only a little more than 2% per year since the recession, which is very low by historical standards. Wage growth for most workers was modest for a couple of decades before the recession due to globalization and other factors beyond the level of economic activity, and those forces are undoubtedly still relevant. But labor market slack has also surely been a factor in holding down compensation. The low rate of wage growth is, to me, another sign that the Fed’s job is not yet done.
My observation of the fed is that they work to suppress wage growth by raising rates before business activity gets so strong that labor can demand higher wages. But that point aside, stagnant wages hurts housing because it doesn’t provide workers the ability to put more money toward housing payments. Combine that with the loss of leverage from higher interest rates, and you have a recipe for lower loan balances and weaker house prices.
3) The large number of long-term unemployed
A third form of evidence related to slack concerns the characteristics of the extraordinarily large share of the unemployed who have been out of work for six months or more. These workers find it exceptionally hard to find steady, regular work, and they appear to be at a severe competitive disadvantage when trying to find a job. The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce. But the data suggest that the long-term unemployed look basically the same as other unemployed people in terms of their occupations, educational attainment, and other characteristics. And, although they find jobs with lower frequency than the short-term jobless do, the rate at which job seekers are finding jobs has only marginally improved for both groups. That is, we have not yet seen clear indications that the short-term unemployed are finding it increasingly easier to find work relative to the long-term unemployed. This fact gives me hope that a significant share of the long-term unemployed will ultimately benefit from a stronger labor market.
The long-term unemployed are broke because they had to spend whatever they had just to survive. Even if they do find a good job, they don’t have any savings. This is pent-up demand that almost certainly will never materialize due to a lack of down payment money.
4) The historic low rate of labor market participation
A final piece of evidence of slack in the labor market has been the behavior of the participation rate–the proportion of working-age adults that hold or are seeking jobs. Participation falls in a slack job market when people who want a job give up trying to find one. When the recession began, 66% of the working-age population was part of the labor force. Participation dropped, as it normally does in a recession, but then kept dropping in the recovery. It now stands at 63%, the same level as in 1978, when a much smaller share of women were in the workforce. Lower participation could mean that the 6.7% unemployment rate is overstating the progress in the labor market.
The federal reserve must keep interest rates low to stimulate employment and to keep mortgage interest rates low to stimulate housing. If interest rates are allowed to rise before the economy strengthens and employment returns, the economy will tip back into recession and housing will languish.