The Federal Reserve’s Rate Hikes Are Cooling The Housing Market But Land-Use Reforms Still Needed

Since the spring of 2022, the Fed’s federal funds rate target—which is the interest rate banks charge one another for overnight loans—has increased to 2.5%, up from 0.25% in February. The Fed’s actions have increased interest rates on everything from credit cards to mortgages. The higher mortgage rates are starting to bring down prices, but the lower prices will be temporary without the supply increases that are needed to make housing more affordable.

The average 30 and 15-year mortgage rates are at their highest levels since 2009, as shown in the figure below from the American Action Forum’s latest housing chartbook by Thomas Wade. The 30-year rate is nearly 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 are below the 6% to 7% rates that were the norm from 2001 to 2009.

While interest rates may not be high by historical standards, the recent increases are still causing prices to fall. Both the Case-Shiller and FHFA housing price indices have begun to level off, as shown in the two figures below.

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

Builder sentiment is declining in response to lower prices and slower price growth. The NAHB/Wells FargoWFC
housing market index—created from a survey of builders who assess housing sales and expectations—has fallen to its lowest level since before the pandemic, as shown below.

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

Fewer housing starts will keep the supply of new homes down and may slow the fall in housing prices as supply adjusts to meet the lower demand caused by rising interest rates. While this may be good for current homeowners who will experience smaller drops in equity in the short-term, it is bad for long-term housing affordability. The country has a significant housing shortage—between 6 million and 10 million units—that a decline in housing starts will only exacerbate. The tight housing market shows up in home and rental vacancy rates, which are at their lowest levels of the past 10 years.

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

It would be a mistake to blame the Fed for the housing market’s issues, though. The Fed is doing what is necessary to curb the runaway inflation caused by too much government spending and its own excessive money creation during the pandemic. Any other effects its interest rate hikes have on the economy are of secondary importance.

The main culprit behind the supply and demand mismatch in the housing market is too much government regulation. The federal government has long been in the business of boosting housing demand through the quasi-government agencies of Fannie MaeFNMA
and Freddie Mac and other government programs.

Both Fannie and Freddie buy mortgages from lenders and have implicit government backing. Since lenders know they can easily offload mortgages to Fannie and Freddie, they are less worried about long-term default risks and thus can keep borrowing costs artificially low.

Artificially stimulating demand is bad enough on its own—remember the housing crisis? —but what makes it even worse in the context of the housing market is that local governments are simultaneously depressing supply via land-use regulations. Across the country, minimum lot sizes, parking requirements, convoluted permitting processes, density requirements, and other local regulations restrict the amount of housing 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 lower- and moderate-income households.

The Fed’s rate hikes are cooling the housing market, and with more hikes forthcoming we should expect this to continue in the near future. The Fed’s impact, however, is minor compared to the adverse impacts of current federal and local government housing policies that boost demand and restrict supply. The Fed’s actions should not distract us from making the long-term changes we need to bring the housing market into balance—more supply at the local level and fewer subsidies at the federal level.