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January 04, 2016

Strong Housing Sector Trumps Tighter Monetary Policy in 2016

Sean Becketti
Sean Becketti, VP Chief Economist*

After more than a year of false alarms, the Federal Reserve finally decided in December to begin tightening monetary policy by raising the federal funds rate. Economists are pondering the impact of this long-awaited Fed action on the U.S. economy generally and on the housing sector specifically.

Housing gathered strength throughout 2015, with home sales posting their best performance since 2007. House prices increased as well, due as much to the tight supply of homes for sale as to increased demand. Some analysts are concerned that the Fed's monetary tightening will boost mortgage rates, reduce affordability, and halt or reverse the recent improvement in housing.

We don't share these concerns – at least for the housing sector. Here's why:

  • The Fed is conscious of the fragile state of the economic recovery and has committed to a gradual pace of monetary tightening. We take the Fed at its word and expect only a few modest hikes in short-term interest rates next year.
  • The connection between longer-term interest rates – like the all-important mortgage rate – and the short-term rates controlled by the Fed is tenuous. For example, back in the mid-2000s, when the Fed raised rates at 17 consecutive meetings, mortgage rates barely budged – they continued to hover around 6 percent.
  • Weakness in the global economy and the stronger dollar will attract global capital flows to Treasury securities, further limiting any increase in longer-term U.S. interest rates.
  • The strong dollar and plummeting oil prices will dampen inflation in the U.S., which, in turn, will provide the Fed with additional incentives to moderate the pace of monetary tightening.

In spite of these headwinds, longer-term interest rates will start to increase in 2016 as the monetary tightening starts to impact economic activity, but the increases in rates like the mortgage rate will be just a fraction of the increase in the federal funds rate and other short-term rates. However, even a modest increase in mortgage rates will reduce affordability, especially for first-time homebuyers and low-to-moderate income borrowers. This reduction in affordability may restrain house price increases at the lower-priced end of the market.

Long-term rates could rise sharply if the Fed begins to reduce the size of the MBS portfolio it built up through quantitative easing (QE). However, this type of reduction is at odds with the gradual tightening the Fed has committed to publicly. We don't expect the Fed to shrink the QE portfolio until the latter part of 2016 at the earliest, and any significant reduction in the QE portfolio isn't likely until 2017.

While we believe the housing sector will remain strong in 2016, there is some uncertainty about the strength of the broader economy. The commencement of monetary tightening indicates the Fed believes the healing of the U.S. macroeconomy is firmly on track. However, the performance of the economy following the Great Recession marks by far the weakest recovery of the post-World War II era. Furthermore, productivity appears to have declined to the point that the economy is unlikely to generate more than two or two-and-a-half percent real growth, and this only if all else goes well. This rate of growth is well below the 3.2 percent real growth rate enjoyed on average during the post-War period.

Here are a few other predictions about housing sector performance in 2016:

Mortgage Interest Rates

The 30-year mortgage rate began 2015 at about 3.7 percent, and it remained under 4 percent for most of the year. Mortgage rates will increase gradually through 2016 in response to monetary tightening – we're forecasting the 30-year rate will average 4.4 percent for the year.

House Prices

The imbalance between housing demand and supply continues to boost prices. We expect house price growth to moderate a bit to 4.4 percent in 2016, still well above the long-run sustainable rate of house price growth. The 2016 moderation in house price appreciation reflects, in part, the reduction in affordability and associated reduction in demand that will follow the Fed's monetary tightening.

Home Sales

Housing activity will grow in 2016, despite monetary tightening. Total housing starts will increase 16 percent from 2015 to 2016, and total home sales will increase 3 percent. While single-family homes will account for most of the construction pickup, rental apartment construction will also increase but not enough to meet the significant demand of this market from both older and younger cohorts.

Single-Family Originations

While home purchases will increase next year, higher interest rates will reduce the volume of refinances. As a consequence, mortgage originations will be lower in 2016 than in 2015 to around $1.58 trillion, down from our projected $1.75 trillion estimate for 2015.

Despite years of sustained low levels of mortgage interest rates, refinance activity has remained unexpectedly high. Our upward revisions to mortgage originations in 2015 came largely from higher-than-expected refinance activity. The volume of refinances may continue to exceed expectations despite mortgage rate increases, especially if the share of cash-out refinances continues to grow.