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Markets and Economy

Mortgage rates are only one part of housing demand

The Fed plans to raise interest rates in 2022, which will reduce homebuyers’ purchasing power. But income, demographics and household wealth—not borrowing costs—are the real drivers of housing demand.

Key points

  • Mortgage rates are almost certain to rise as the Fed adopts a neutral monetary stance.
  • This will reduce the purchasing power of homebuyers and slow down red-hot markets.
  • Still, the underlying demand for housing is driven by income, demographics and household balance sheets, both of which should remain relatively strong.
  • The housing market historically does well during periods of full employment and neutral interest rates.

The Fed’s tightening will affect housing prices

Interestingly, the pandemic created favorable conditions for the housing sector—driven mainly by a plunge in 30-year mortgage rates from 4% to 3% and an increase in household incomes. Once mortgage rates tick back up, borrowers may not be eligible for the same size mortgages they’re receiving in the current market. The Federal Reserve is ending asset purchases and is expected to raise interest rates steadily over the course of this year, which could erode some homebuyers’ purchasing power.

  • The Fed doesn’t directly set mortgage rates, but rates will likely rise along with bond yields as pandemic-era support is removed. 
  • Bidding wars may become rarer as buyers have less access to credit, meaning housing prices should cool.


The other factors at play

If a return to higher interest rates is accompanied by full employment and steady wage growth, demand for housing should remain strong.

  • Fiscal relief funds during the pandemic lifted household net worth to historic highs.
  • Employers responded to worker shortages by raising wages, which is boosting income growth and will cushion the impact of higher interest rates.
  • Workers who went remote could finally move further from their offices to more affordable communities, no longer limited by commuting costs. In some cities, that population shift has displaced many of the workers who previously provided vital support services to nearby businesses.
  • History tells us housing can keep momentum even as rates rise. In the 1990s and early 2000s, construction activity maintained a sustainable pace of about 1.5 million new homes annually, despite mortgage rates that stayed above 5%.


Housing demand is driven by household formation

Young adults have long been motivated to move out on their own. But that didn’t happen as often during the Great Recession, when the difficult job market dragged down housing construction between 2008 and 2012. Despite low borrowing costs and a depressed real estate market, relatively few young people were on solid enough financial footing to live independently, and the rate of new household formation stalled. Now, the opposite effect is likely in play.

  • With unemployment below 4%, working young adults will create strong demand for new units, even if housing is not a bargain. 
  • Population flows towards the South and Mountain West will also continue to create demand for new housing stock.
  • Real estate construction follows population trends, which show populations growing slowly—or shrinking—in the Midwest and Northeast states, counterbalanced by aggressive growth in the Southeast, South and Mountain West states.


What to watch

Housing prices have climbed steeply over the past two years, and they are likely to moderate to their pre-pandemic trend as interest rates rise. The total number of households should continue to climb if the labor market remains strong, creating underlying demand for new construction, which could continue to average about 1.5 million housing starts annually.

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