The Big Idea
Housing market trying to weather the storm
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The housing sector tends to be the part of the economy most sensitive interest rates. This was evident in 2022 with the plunge in activity after the Fed began to raise rates and mortgage borrowing costs surged. At the moment, builders and other industry players are hopeful that looming Fed rate cuts will spark a pickup in homebuyer demand. However, in the meantime, the near-term outlook is difficult, as the spring selling season was a bust and homebuilders are currently stuck with bloated inventories, which will likely require a pullback in housing starts for a while.
Affordability remains a problem
The National Association of Realtors publishes an affordability index, which measures the home price a household with the median income can afford based on the standard recommended income-to-monthly-payment ratio. Income, home prices and mortgage rates go into calculating the index. The index is at 100 when the median income is just enough to qualify for a mortgage on a home at the median national price.
The combination of high home prices and elevated mortgage costs has led to a massive deterioration in affordability since the beginning of 2022, back when the Fed was still maintaining its policy rates at the zero bound. There is a close connection between affordability and home sales (Exhibit 1).
Exhibit 1: NAR affordability and combined new and existing home sales
Source: Census Bureau, NAR.
Over the last few years, not only is the correlation strong, but it seems that home sales respond to the relatively small wiggles in affordability, which mostly correspond to swings in mortgage rates (Exhibit 2). There is a lag of a few months, exactly what should be expected in light of the reporting delays in the sales data (existing home sales are recorded at contract closing).
Exhibit 2: NAR affordability and combined new and existing home sales
Source: Census Bureau, NAR.
The takeaway is that the slide in home sales over the past few months is no fluke. The June reading was the lowest since 2011—though, to be fair, it was only barely weaker than the last three months of 2023—while the NAR affordability gauge in May, at 93.1, was only marginally higher than the lowest reading of late 2023. Otherwise, the NAR affordability index in late 2023 and in recent months is the lowest since 1985, when 30-year mortgage rates were 12%.
Homebuilders swing and miss
Late last year and early this year, there was a widespread expectation that the FOMC would be cutting rates early and often in 2024. Homebuilders took that outlook to heart and made a bet that housing demand would perk up once borrowing costs began to recede. Single-family housing starts jumped by at least 100,000 units per month (annualized) from November through March (Exhibit 3). The plan was to have a hefty inventory of homes to sell when the spring selling season began, the peak time of the year for homebuying.
Exhibit 3: Single-family housing starts
Source: Census Bureau.
This logic may have made sense at the time, but inflation reaccelerated in early 2024, mortgage rates jumped back above 7%, and the spring selling season was a bust. As a result, homebuilders are left with a lot of inventory.
By June, total new home inventory reached a level only seen during the height of the housing boom, when the rate of sales was far higher than current levels (Exhibit 4). The months’ supply in June was 9.3, far above the 6-month mark that is generally viewed as consistent with a balanced market and the highest since 2022.
Exhibit 4: New Home Inventory
Source: Census Bureau.
Builders have already begun to slow down the pace of housing starts. The pipeline of homes for sale that are under construction has already peaked (in March) and has begun to come off (Exhibit 5).
Exhibit 5: New homes for sale that are under construction
Source: Census Bureau.
However, completed new homes on the market continue to accumulate significantly (Exhibit 6). The June reading exceeded 100,000 for the first time since 2009. Thus, homebuilders will likely need to continue trimming their pace of construction for a while longer to bring supply and demand back into balance.
Exhibit 6: Completed new homes for sale
Source: Census Bureau.
Economic implications
The housing component of real GDP represents only about 3% of the total, so it takes big swings in housing to substantially move the needle for the overall economy. For example, the roughly 25% annualized drop in activity in late 2022 was worth over a full percentage point for two consecutive quarters. The 16% surge in activity in the first quarter of 2024 was worth six tenths of a percentage point for real GDP growth. In contrast, the 1.4% annualized decline in the housing sector in the second quarter was worth a mere half of a tenth of a percentage point—essentially rounding error.
I expect residential investment to contract modestly in the second half of this year, perhaps at around a 3% annualized pace, as builders continue to manage down their inventories. By 2025, with rates falling and inventories presumably closer to desired levels, housing activity could begin to expand again. Still, the implications for GDP growth are likely to be modest, perhaps a drag of one to two tenths of a percentage point later this year and a similarly sized boost moving into 2025.
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