Finding Balance with Supply and Demand

The housing market rebound is limited by a “weird economy”

By Patrick Duffy

These days, if you search online for “weird economy,” you’ll find no shortage of opinions and analyses on why the United States economic engine continues to yo-yo between good news and bad. For the new housing market, it makes finding that balance between supply and demand even more difficult, especially with mortgage rates behaving as a moving target susceptible to multiple threats.

Although mortgage rates had dipped closer to 6% in early February as it seemed that the Fed’s efforts to tame inflation were working, more recent economic updates suggest that its Federal Funds rates will need to go even higher and stay there longer than financial markets have been betting. 

Besides the blockbuster employment report for January reporting over 500,000 new jobs (and which will likely be revised downward in the future as more information comes in), unemployment fell to just 3.4%, a 54-year low. When unemployment is this tight, it’s difficult to keep annual inflation close to the 2.0% benchmark preferred by the Fed. While legal immigration could provide some additional labor market slack to limit wage increases, for now reforming national immigration policy remains stuck in limbo.

Retail sales also surprised to the upside in January, especially for bars and restaurants as both demand and staffing have continued to rise, with sales jumping over 25 percent year-on-year. It seems that while the average household is well aware of an economy that may see a recession later in 2023, their own personal finances are healthy enough to boost spending.

Although inflation had seemed to be on the retreat towards the end of 2022 as snarled supply was cleared, more stubborn price increases related to the service sector and wages led to some rebounds in both the Consumer Price Index and the Producer Price Index in January. Whereas the CPI rose 0.5% in January after rising just 0.1% the month before, the PPI rose by 0.7% after falling 0.2% in December.

Since input costs faced by producers often filter out to the consumer, this could mean sustained higher inflation for the CPI in the months ahead. Moreover, since the ‘core’ PPI minus food, energy and trade services rose by 0.6% in January, it’s quite possible that inflation is no longer related to pandemic-related backups but has instead infiltrated into the larger economy.

The Federal Reserve has three options it can pursue, each of which has consequences. It can soldier on with its current insistence on forcing inflation back to 2.0 percent, but that could lead to a recession. It can accept the higher rates of inflation which usually accompany tight labor markets – somewhere between three and five percent – but that would hurt investors in both stocks and bonds and keep mortgage rates elevated. Or it can try to pivot to a higher baseline rate of inflation with a policy change that avoids political and economic turmoil while also attempting to successfully engineer a “soft landing.”

So what does this mean for the housing market? For sellers of existing homes, it could mean fairly substantial price cuts to make a sale. But for home builders with a larger arsenal of sales incentives available, it could spell opportunity. According to the NAHB’s Housing Market Index for February, 57% of builders were offering such incentives such as interest rate buydowns and design center allowances compared with 31% reducing prices averaging 6% of the sales price. If 85% of homeowners are paying mortgage rates below 5% (and two-thirds with rates under 4%), mortgage rate buy downs could become more standardized throughout 2023 to move unsold inventory.

Another advantage for builders of new homes is the growing single-family build-for-rent (SFBFR) market. According to an analysis of Census Bureau data by the NAHB, in 2022 there were nearly 70,000 SFBFR starts, or up one-third from 2021 levels. If this market is currently estimated to account for seven percent of starts, and an equal amount of estimated starts include investors who purchase new single-family homes separately to rent them out, that total share could provide builders with enough demand to keep their core operations going. The weird economy is likely to stay for some time to come.

Patrick Duffy contributes as a Real Estate Economist for U.S. News & World Report and is the Founding Principal of MetroIntelligence.