The Housing Transition Channel Isn’t Working
The idea that interest rates are not high enough is beginning to gain a foothold at the Federal Reserve.
Neel Kashkari, our esteemed monetary shepherd from the Minneapolis Fed, has once again taken to the digital pen with commendable transparency to point out that the economy is not behaving as you might expect it to if the Federal Reserve’s monetary policy were all that restrictive.
Kashkari’s focus is on the housing market. This makes sense. Housing is considered one of the most interest-rate-sensitive segments of the economy because homes are typically purchased with mortgages. As a result, the housing market is one of the primary channels through which monetary policy is transmitted to the real economy.
Here’s how that works. When the Fed raises its target for overnight interest rates for loans between banks, this tends to raise yields on longer term bonds because these are essentially just a series of short-term loans. Because mortgage-backed securities are a somewhat close substitute for Treasuries, mortgage rates tend to follow the yield on 10-year Treasuries.
Higher interest rates make buying homes less affordable. They can either depress home prices or at least slow down the rise in prices by reducing demand. They also tend to slow down home building, which is an economically intensive activity that employs lots of labor, materials, and manufactured products. So, if you can slow down the housing market, you can probably slow down the economy and reduce inflation.
Home Prices, Home Building, Rents, Construction Are All Rising
Except that does not seem to be happening. Kashkari points out that after residential investment fell in the early months of the Fed’s tightening cycle, it has “since reversed and has grown 5 percent over the past year.”
He could have also pointed out that the S&P CoreLogic Case-Shiller U.S. National Home Price Index is up 6.4 percent through February (the most recent month available), an acceleration from the 6.0 percent annual gain in January. The 20-City Composite index, which is what Wall Street tends to focus on, posted a year-over-year increase of 7.3 percent.
Minneapolis Fed President Neel Kashkari speaks during an interview in New York on Nov. 7, 2023. (Victor J. Blue/Bloomberg via Getty Images)
And Americans think home prices are going to keep rising. The New York Fed’s recent Survey of Consumer Expectations found that average one-year-ahead home price growth expectations increased to 5.1 percent in February 2024 from 2.6 percent in February 2023. While that is lower than the 2022 series high of seven percent, it is also the second highest reading in the history of the survey.
How about rents? The consumer price index for residential rents was up 5.7 percent over the 12 months through March. While the month-to-month increases fell sharply in the first half of last year, over the past seven months they have been in a range of 0.3 percent to 0.6 percent, very elevated compared with the 10 years before the pandemic. The New York Fed survey shows that households expect rents to increase by 9.7 percent over the coming year, reversing last year’s decline to an expected 8.3 percent increase.
Housing starts tell a similar story. They fell steeply in the first few months after the Fed started raising rates, but this downward trajectory ended in the summer of 2022. Since then, starts have bounced around within a range much higher than was typical pre-pandemic.
Employment in home building is also running hot again. After plateauing in the months immediately following the Fed’s first interest rate hike, it began rising again last August. There are now 100,000 more people employed in home building than there were prepandemic, when things were running at the highest level since the bursting of the housing bubble. In fact, the last time so many people were employed building houses was the summer of 2007.
This cuts the legs out from under the interest rate doves who say that shelter inflation is somehow distorting the overall inflation numbers because of lags in the way it is calculated. The idea that shelter will stop being a major contributor to inflation falters on the fact that home prices and rents keep rising rapidly.
The Neutral Rate May Be Higher
Kashkarai argues that the “resilience” of the housing market suggests that the neutral rate of interest—the rate that neither holds back nor stimulates the economy—has likely risen from the very low levels that we experienced in the decade or so before the pandemic. As a result, the level of interest rates necessary to push inflation down to the Fed’s two percent target is likely higher than thought.
In other words, rates might not be as restrictive as many Fed officials and Wall Street economists think. And that, in turn, suggests that rates might need to be higher if they are going to do the job of taming inflation.
The data, however, suggests an alternate explanation. Instead of the problem being the absolute rate of interest, it may be the very fact that the Fed’s stopped raising rates that is important. If the restrictiveness of rates comes not from their level but from the fact that they are rising, the Fed’s decision to stop raising last summer is a form of easing. What matters when it comes to inflation may be the rate of increases instead of whether rates are high or low in some objective sense.
“Once the policy rate remains stable and the transition dynamics work their way through (‘long and variable lags’), the higher policy no longer appears contractionary,” economist David Andolfatto wrote in a blogpost back in February.
The further implication is that the Fed’s signal that its next move will be an interest rate cut is itself expansionary. The market—and corporations, especially homebuilders—don’t have to wait for the cuts to come. They’ll start executing their expansion plans in anticipation of the cuts.
This suggests that the Fed probably will need to restart interest rate increases to get inflation to start falling again.
