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What if rising interest rates make inflation worse?

This week, the Federal Reserve Board announced the first of what is likely to be a series of increases in short-term rates to bring down inflation. But what if rising rates don’t impact inflation? Higher mortgage interest rates help slow down the economy as housing demand is reduced, creating downward pressure on prices. However, in this pandemic-driven economy, supply is the biggest driver of housing prices, and demand is already constrained by record-low inventories of available and affordable homes. One possibility is that rising rates could add to inflationary pressures by increasing the cost of buying and renting a home, inflating the shelter cost number in the Consumer Price Index (CPI) because there is not an adequate decrease in demand. Since housing price increases lag CPI, shelter could become an even larger driver of inflation as other pandemic-related supply chain back-ups resolve. The less supply, the more likely this outcome becomes.

First, let’s look at how the Fed’s decision impacts housing and inflation during normal times. Interest rate increases are decided by the Federal Open Market Committee (FOMC), comprised of the members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. They vote on changes to the Federal Funds Rate, the interest rate banks charge each other to lend Federal Reserve funds overnight. This overnight interest rate is used as a benchmark for other short-term rates like the Prime Rate, which have a more direct impact on mortgage rates.

So, while the Fed is not directly increasing mortgage interest rates, it is increasing the cost of funding most mortgages. Anticipation of rising short-term rates can increase long-term rates as investors prepare for increased funding costs. As a result, we have already seen mortgage rates increase from less than 3% a year ago to more than 4% today.

Higher interest rates impact housing in two ways. First, the cost of buying a home increases, making homeownership more expensive. Second, the cost of new homes increases with the cost of financing new construction.

But today’s housing market is different in some significant ways that could alter these assumptions. First, housing inventory is at record lows while housing starts are near capacity. Housing inventory has more than halved since the start of the pandemic, from 1 million active listings in January 2020 to a little over 400,000 in January 2022, according to data from the Federal Reserve.

Builders are already constructing as many homes as they can. Privately?owned housing units authorized by building permits in February were at a seasonally adjusted annual rate of 1,859,000. The capacity to build more is constrained by a tight labor market, housing supply shortages, and local zoning restrictions that continue to keep land costs high. Yet many of these projects have yet to break ground due to supply chain problems, and material and labor costs.

If higher interest rates reduce production more than demand, prices will remain high. Mortgage rates rose from less than 10% in 1978 to nearly 18% in 1981. Production plummeted.
While home prices remained fairly stable, the US suffered two massive recessions in three years, which broke the back of inflation–-along with the financial health of millions of families.

Falling production in today’s market is likely to exacerbate our housing affordability crisis, fueling increases in rents as homeownership rates fall. Higher rates will also do nothing to reduce the price of oil or supply chain disruptions impacting commodity prices like lumber, steel, and copper – essential elements of new home building that have already experienced huge price increases.

While the President’s ability to influence inflation is limited, he does have tools at his disposal to address housing supply. I am hopeful that we will see President Biden take a more public leadership role. In a recent Politico article, one administration official said, “We don’t ask the question, ‘Can we solve the challenge entirely?’ It’s, ’Can we make a difference?’ And I think there are federal levers here that make a real difference.” That’s a valuable strategy, but only if the President is leading.

Construction costs, housing supply, and inflation were discussed at a meeting held by the White House last week that we attended along with representatives of the National Association of Home Builders, and several of our members, including the Atlanta Neighborhood Development Partnership, Low Income Investment Fund, National Equity Fund/LISC, Eden Housing, and Habitat for Humanity International.

NHC offered four policy priorities to improve single-family and multifamily production.

  • Negotiation of a Comprehensive Softwood Timber Agreement with Canada
  • Passage of the Affordable Housing Credit Improvement Act (AHCIA)
  • Passage of the Neighborhood Homes Investment Act (NHIA), and
  • Formation of a President’s Council on Housing Affordability

I wrote about the first three in my February 21 Member Note. Last week, NHC led a coalition of more than 40 housing leaders to send a letter to President Biden requesting that he create a President’s Council on Housing Affordability. We hope that this Council will increase the focus on housing affordability at the highest levels of the White House while generating new ideas to address the housing supply crisis. The White House has supported both the AHCIA and the NHIA as a part of its Build Back Better legislation. Together, these bills would produce more than 2 million affordable homes over ten years. Now we need the President to press Congress to move these bills now. They have broad bipartisan support and offer all Members of Congress the opportunity to vote on two important issues among voters–-housing costs and inflation.

If we fail to address shortages in housing supply, we run the risk of fueling the fires of inflation rather than extinguishing them. The result could be stagflation, a word most of us haven’t used in a generation–-high inflation and economic recession. This would devastate the housing economy and only exacerbate our current housing supply challenges. As we stated in our letter to President Biden, “Housing is a continuum. Lower homeownership rates lead to higher rents where demand exceeds the already severe shortage of housing affordable to the lowest-income households. This, in turn, may increase homelessness among those already struggling to afford shelter.”

The bottom line today: If we want to beat inflation, reduce housing costs and homelessness, and help avoid a recession, we have to build more housing.

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