The Fed's Plan to Reset the Housing Market - 3 Things You Need to Know

The Fed has a problem: Inflation.

Inflation is a tricky thing, and one that I won’t pretend to fully understand or try to discuss entirely here. What I do know though, is that the Federal Reserve has been making clear for some time now that they are willing to lay the housing market on the altar in order to rein in inflation if need be, and that is something that you should know more about.

To that end, the Chairman of the Federal Reserve, Jerome Powell, told us in June that rising mortgage rates would bring an end to the Pandemic Housing Boom, and what’s more, he thought that was a good thing:

“I’d say if you are a homebuyer, somebody or a young person looking to buy a home, you need a bit of a reset. We need to get back to a place where supply and demand are back together and where inflation is down low again, and mortgage rates are low again.”

It’s hard to argue with that line of reasoning, but what the heck is a “reset” and why is the Fed Chairman talking about it in regards to the housing market? This question has become a bit of a central theme amongst many economists of late, with many wondering what Powell means when he uses the term. Does the Fed want Buyers to stop buying homes long enough for inventory to rise? Or does “reset” mean the Fed wants home prices to come down? Or both? Or something else?

Powell finally defined the term for us this week.

Well, sort of.

When asked to clarify the Fed’s idea of what a housing reset looks like, we got this winding response:

“When I say reset, I’m not looking at a particular specific set of data. What I’m really saying is that we’ve had a time of a red-hot housing market all over the country, where famously houses were selling to the first buyer at 10% above the ask even before seeing the house. That kind of thing. So, there was a big imbalance between supply and demand. Houses were going up at an unsustainable fast level. So, the deceleration in housing prices that we’re seeing should help to bring prices more closely in line with rents and other housing market fundamentals. That is a good thing. For the longer term what we need is supply and demand to get better aligned so that housing prices go up at a reasonable level and at a reasonable pace and that people can afford houses again. We probably in the housing market have to go through a correction to get back to that place. There are also longer-run issues with the housing market. As you know, it is difficult to find lots now close enough to cities, so builders are having a hard time getting zoning and lots and workers and materials and things like that. But from a business cycle standpoint, this difficult correction should put the housing market back into better balance.”

While we didn’t really get a straight answer, Powell provided us with enough clues that we can at least make some conclusions about where the Fed sees this whole housing reset taking the housing market.

Here are 3 of them:

#1 - We are in a housing correction, which by definition, is a period of home price decline

The party that seemed like it would never end finally kicked the bucket this spring when the Fed finally started raising rates. At first, it was almost as if no one could believe it was happening. Everyone was in denial about it. In fact, some still are. What began as a mild slowdown has since, shall we say, intensified. On a year-over-year basis in Weld county, inventory is up nearly two-fold while closings are down by nearly 40%.

Those who refused to believe it was happening started to call it a normalizing market. They would post screenshots of a home that sold recently and another of the last time it sold, pointing out things like how much more money that was than before, and other useful insights. This, they would say, was proof that it is never a bad time to buy a new house.

But make no mistake about it, the Fed does not see it this way. In fact, they are very intentionally pushing us further and further into the correction and it is all very much intended to be this way. Just this week, Powell doubled down on what the Fed is trying to do here:

“For the longer term what we need is supply and demand to get better aligned so that housing prices go up at a reasonable level and at a reasonable pace and that people can afford houses again. We probably in the housing market have to go through a correction to get back to that place. This difficult correction should put the housing market back into better balance.”

Mark Zandi is a guy who knows things. In fact, he knows so much that he gets to be the chief economist at Moody’s Analytics. What’s more, he’s one of the few people out there who have seen most of this coming and been jumping up and down about it for the last two years. Since the moment the Fed started raising rates, Mark has been telling everyone that the correction is coming. Now that it’s here, he sees only one feasible outcome as a result: home prices must fall. How much home prices fall depend largely on how overvalued the current regional market is, but be advised, the northern Colorado Market is not immune here.

While the Fed has yet to admit it openly, it is clear now that when they say, “reset” they mean, “correction” indicating that they are open to the idea of home prices falling, sales declining, and construction pulling back so long as such outcomes help them in achieving their primary objective of controlling inflation.

And in fact, we are seeing this already. Zillow, who for all their foibles have become one of the gold standards in housing data, reported this week that 117 regional markets have posted price declines since May. Some are down big, with parts of CA posting over a 10% decline. Others are smaller, like Denver’s 4.3% decline. The point is, home prices are already dipping in many markets.

The reason we're vulnerable to falling home prices is pretty simple. The Pandemic Housing Boom saw home prices across the country soar far above what incomes would historically support. Low interest rates kept the party going, but ended up as collateral damage when the Fed finally declared war on inflation this summer.

The point is, the longer mortgage rates stay elevated, the more the housing market is going to feel the Fed’s “reset” mode. Simply put, that means prices will continue to fall because there is simply no other alternative here.

#2 - The housing correction should bring balance back to the market, but that is not a guarantee

It’s a common misconception that there are a lack of homes in the U.S. What I’ve always said and still say today is that there is a lack of homes that Buyers considerable affordable in the U.S. I’ve talked about this before and been called a liar, but some people don’t appreciate the truth like you and I. Then in June of this year, the Fed got word that I needed some backup and published a paper discussing its findings that the Pandemic Housing Boom was primarily driven by demand surge – not supply constraints.

"Even though the supply of new for-sale listings fell sharply at the beginning of the pandemic, we show that reduction of supply was a minor factor relative to increased demand in explaining the tightening of housing markets over the first year of the pandemic," wrote the Fed researchers. "Our estimates imply that new construction would have had to increase by roughly 300% to absorb the pandemic-era surge in demand."

Well, the Fed’s reset sure has halted that demand boom. The perks needed to fill the gap between a 3% and 6% mortgage just can’t be found in places like Boise, Idaho I guess. And good luck turning a profit flipping houses with a 7% investor loan and $5 2x4s. From work-from-home professionals to flippers to second-home buyers, pretty much everyone has backed off the housing market in the last 3 months.

# 3 - The Fed wants the housing correction to spread to impact the whole economy, but their mandate isn’t affordable housing - a fact that you’d be wise to remember

The Fed’s housing reset is, at its core, not really about housing.

The Fed has only two mandates: maximum employment and stable prices. In other words, low unemployment and low inflation.

To that end - and as crazy as it might sound - the Fed will happily sacrifice something like the housing market if it serves the purpose of helping them to control inflation.

Housing is nothing more to the Fed than a transmission mechanism in its efforts to project its influence in order to control one of the two things it is mandated to control. As such, the housing correction is simply a means to an end and nothing more as far as the Fed is concerned.

Here’s how it works: the Fed increases interest rates, which in turn applies upward pressure on the cost to borrow money – such as a mortgage. As mortgage rates move higher, home sales and new homebuilding decline. That causes demand for things like lumber and plumbing contractors to fall. These declines, once sustained for a long enough period of time, will begin to spread to other parts of the economy and, in theory, weaken the labor market and help tame inflation.

Powell has indicated that until inflation is reigned in to meet the Fed’s 2% target, it will be their central focus – even if that means pushing the U.S. economy into a recession to achieve it.

Read that again.

Of course, in a perfect world the Fed’s housing “reset” would return us to a balanced housing market, but at the end of the day, the Fed’s mandate isn’t to provide you and I with affordable housing. That being said, if the current efforts to stem inflation do not produce the desired results, make no mistake that the Fed will continue to offer up the housing market as a sacrifice in an attempt to fulfill their mandate.

As such, there is absolutely a scenario here where the Fed pushes so hard on the housing market that it pushes the whole economy into a recession. However, if we end up in a recession that is so deep that new homes stop being built, that won’t do too much for helping us make any progress in attaining the balanced market Powell has been babbling about this past week.

The take home message is that everyone needs to be keenly aware that the Fed will not think twice at this point about the notion of throwing the housing market to the lions if they think it might help bring inflation under control.