The housing sector's remarkable resilience during the Fed's historic monetary tightening cycle has been a key factor supporting the economy's resilience to recession. Housing, a large and volatile sector of the economy, is typically an important transmission channel for monetary policy that affects real economic activity. When interest rates rise, the price of buying a home falls, people buy fewer or smaller homes, and the pace of home construction slows.
With around 8 million construction workers and 4% of GDP, the sector is large enough that a recession within the sector, combined with spillover effects on related activities, could cause a true recession. And because housing is sensitive to interest rates, it typically leads the business cycle and provides clear clues about where the economy is headed.
But even though housing starts, or new housing units, have fallen by 25% since last year, construction sites have not seen widespread layoffs. why?
First, builders were understaffed before the pandemic, so even when construction starts began to decline, they never actually became overstaffed. Second, supply chain issues in 2022 have lengthened the time it takes to complete housing units. This means that even though construction starts have declined, units under construction remain at a high level, requiring more workers than usual. Third, the interaction between inflation and the tax law has caused real after-tax mortgage rates to rise less than nominal rates.
In fact, non-residential investment has been increasing aggressively recently, thanks to the stimulus that Congress and the Biden administration have irresponsibly injected into the economy. Spending from the Infrastructure Investment and Jobs Act, the CHIPS Act, and the hyperinflationary Inflation Control Act is creating a boom in nonresidential construction.
All these factors together indicate that even if a recession is on the horizon, the construction industry will not be at its epicenter or its direct cause. This is in contrast to some previous cycles.
Furthermore, the decline in housing starts appears to be partially reversing. The latest data shows that construction starts have jumped by about 20%, close to the 2021 boom (although this increase may be revised downward later). Meanwhile, despite the fastest monetary tightening cycle in history and a steep decline in home prices, homebuilder stocks remain within striking distance of all-time highs.
How do we reconcile these forces? The recession would have been delayed if construction employment had not fallen first (which would have happened around the end of last year in a normal cycle). Although the economy continues to expand, the demand for housing remains. People are still having children, getting married, changing jobs, retiring, and moving between regions and countries.
However, 62% of current mortgages are fixed at interest rates below 4%, and almost a quarter are fixed at interest rates below 3%, making households unwilling to move unless absolutely necessary. There are almost no If he refinances that mortgage, his interest payments will increase to nearly 7%. This “rate lock” prevents households from moving and keeps existing housing inventory on the market at very low levels. In other words, the economy has so far avoided a large drop in employment, so housing supply has fallen in line with housing demand and prices have remained relatively stable.
With inventory of existing homes suppressed, home builders are taking up a larger share of transactions as households with older mortgages can bring their inventory online if they want to keep interest rates low. From 2021 to April of this year, sales of existing single-family homes fell by 29%, while sales of new homes fell by just 11%.
The key to the puzzle is the lack of existing inventory due to rate locking. As long as these homes remain off the market and supply is constrained, the housing market is likely to remain strong. So what would cause a large enough increase in existing housing inventory to move the housing market?
The most likely answer comes through changing business realities. As my colleague Alison Schrager has argued, remote work can reduce productivity for companies. This is because employees spend less time face-to-face. It can also be more difficult for younger employees to gain guidance and skills and impress their bosses for promotions. While many workers will likely want to work remotely most of the week, many companies may want to work remotely less than that, or even not at all. Given the tight labor market, workers have increased bargaining power and many companies are offering flexibility to remote work, especially in the suburbs around major cities. With interest rates currently above 5%, the pace of layoffs will begin to accelerate in the non-residential sector, which is less responsive to interest rates than the residential sector. But they will eventually respond.
As the labor market begins to loosen, bargaining power should shift from workers to employers. When companies decide to reduce their workforce, it becomes easier to limit the number of remote working days, potentially to zero. If the employee doesn't like it, he or she will volunteer to join the ranks of those being laid off. Indeed, there are signs that this process is underway in the technology and financial sectors, where layoffs are occurring.
As remote work recedes, more families will likely move. A large house two hours away from the city makes a lot of sense for a worker who commutes one day a week, but it makes less sense for a worker who commutes every day. Many households that purchased large homes far from downtown will choose to reverse that decision.
Replacement due to reduced remote work will free up elusive existing housing inventory. Households forced to relocate due to changes in commuting requirements may increase market circulation and inventory, driving home price corrections. This is especially true in suburban towns, where prices have increased by 20% to 40% since the pandemic, while central cities have seen stable, slightly rising, or even declining prices.
In other words, if the job market improves, the housing market is likely to improve as well. We live in a world of multiple equilibria. A particular equilibrium may feel stable, but then suddenly becomes unstable. It often takes a large shock to move the world from one equilibrium state to another. The Fed's interest rate hike cycle is one such force.
If the housing market weakens at the same time as the employment market, the economic downturn will naturally accelerate. The housing market's defiance of interest rates so far has disrupted the normal order of leading and lagging indicators, and to the surprise of most economists, counterintuitively, housing has become a lagging indicator in this cycle. It means there is a possibility. This also means that when a recession finally arrives, it is likely to come quickly and strongly.
Photo: Andriy Yalansky/iStock
