Going into 2019, my forecast is that inflation will remain subdued and the Fed will not increase interest rates. With mortgage rates contained and household wages growing, I anticipate the housing market will see a rebound in sales, inventories will be moderate, and prices will continue to rise.
Who am I to make this prediction? Let me back up and give you some background on myself and an overview of how I view the world and why I look at it the way I do. In other words, I want to tell you what I’m looking at to come up with my forecast.
I am an applied macroeconomist using theory to guide my analysis of historical data and understand what the future may bring. Having worked on issues in monetary policy, international finance, and financial crises for over 40 years, I am convinced that understanding the behavior of broad macroeconomic aggregates, like GDP growth, unemployment, and inflation does much to shed light on the behavior of central bank officials and thereby interest rates, housing prices and construction activity, as the behavior of central banks affects these factors as well as the macroeconomic aggregates.
Monetary policy and housing - how they fit together
While it may seem that the central banks and monetary policy are far removed from personal finance and even further from the decision to tap home equity, the reality is houses are far and away the largest investment (and liability for those with mortgages) of all but the very wealthiest of Americans. The connections between and interactions of economic conditions, monetary policy, and housing prices abound. Look no further than the 2008 financial crisis for a stark example of what can happen when falling housing prices interact with over-indebted households and over-leveraged banks. Consider the chart below, which shows that state-level home prices largely follow the same ebbs and flows, suggesting a common macroeconomic cause.
Source: Freddie Mac
This is not to say, for example, that building restrictions in one city don’t impact home prices there. Rather, the idea is that things like wage growth and interest rates have an impact at the individual level, in their ability to purchase homes, and at the national level. So, the better you understand the labor market and the options available to the Fed, the better you can understand how likely certain outcomes are in the housing market.
With that said, it makes sense to quickly review three things: where we are in the economic cycle; what’s going on in the labor market; and what we can expect from the Federal Reserve.
Economic expansion has been long, but recovery has been slow
The economic cycle, also known as the business cycle, is a natural rise and fall of economic growth over time. We are currently in the second longest expansion, i.e., growth phase, in U.S. history. With growth comes increased employment, higher wages, and historically, inflation.
It has been nearly 10 years since the end of the Great Recession induced by the global financial crisis in 2008. The unemployment rate has fallen from nearly 10 percent in 2009 to 4 percent today1. This rate has ticked up slightly from September only because labor force participation, i.e., the percentage of the population working or actively looking for work, has increased. This is a good thing.
While the expansion has been long, the recovery has been slow. Average GDP growth has been consistently lower than it has during other expansions, and wage growth has been, until recently, sluggish. The implications are important. Traditionally, when unemployment has been this low, the Fed would be raising interest rates relentlessly, due to a fear that the low levels of unemployment would spur a bidding war among employers, which would push wages and eventually prices up, i.e., inflation.
The state of interest rates and home prices
The Fed began to raise interest rates in 2018, driving mortgage rates up as well. Recently, however, the Fed has signaled a pause in rate hikes. This combined with rates still being extremely low by historical standards have resulted in mortgage rates falling in recent months.
Fed Chair Jerome Powell has signaled an unprecedented willingness to let wage growth continue to grow and only resume rate hikes if price inflation follows. I consider average hourly earnings and the consumer price index, as well as how they progress, to be integral in understanding what will happen to the housing market and the economy as a whole over the next 6-18 months.
Looking at the chart below, the purple line shows the average hourly earnings of non-supervisory employees, and the orange line shows the annual change in the consumer price index, excluding food and energy, which are two of the more volatile components. If price inflation begins to rise inline with wage inflation, i.e., should the orange line start to follow the purple line higher, the Fed will have no choice but to raise interest rates significantly, which will undoubtedly push mortgage rates higher.
Source: BLS, FRED
A higher mortgage rate means a higher monthly payment. For instance, the average 30-year mortgage rate2 rose from 3.94 in December of 2017 to 4.55 one year later. While this may not seem like a large change, it increases the monthly mortgage payment by 8%, all else equal. This is a definite headwind facing the housing market.
This rise in rates combined with a real estate cool-down, after a particularly hot housing market, has helped house price growth slow and inventory rise.
Source: NAR, S&P, Bloomberg
Inflation to drive the housing market
To summarize: The main driver of the housing market this year will be the U.S. inflation rate. If inflation remains subdued, the Fed will stand pat on interest rates. In this environment, U.S. household income will rise at a moderate rate and financial conditions will support the housing market. This optimistic outlook comes with a note of caution, however: Be on the lookout for any evidence that inflation might return from wherever it has been hiding. Future blogs will help you keep track.
Mike Dooley is Figure’s Chief Economist. He is Professor Emeritus at the University of California, Santa Cruz and a research associate at the National Bureau of Economic Research. His academic career followed more than twenty years service at the Board of Governors of the Federal Reserve System and the International Monetary Fund. At the Fed and the Fund he was responsible for a variety of judgmental and model based economic forecasts. He was Chief Economist for Latin America at Deutsche Bank and a partner in Cabezon Capital. His published research covers a wide range of issues in macroeconomics including work on financial crises and liberalization of financial markets.