After falling steeply for months, homebuilding showed a marked surge in activity in May. This news speaks to the emergence of crosscurrents often brough by inflation to the residential real estate market. On the downside are the depressing effects of rising mortgage rates. Running counter to that effect are the marked attractions real estate offers as an inflation hedge. The emergence of this second positive current should introduce a welcome moderating influence on the negative effects of high and rising mortgage rates — on homebuilding and on the economy generally. At the same time, the use of real estate to hedge inflation shows that people expect general inflationary pressures to last, and those expectations will make the Federal Reserve’s (Fed’s) inflation fight more difficult.
Without accounting for this crosscurrent, the data on residential real estate would seem contradictory and confusing. New home construction hit a high in 2021, when mortgage rates hovered at historic lows and the effects of pandemic effects on lifestyles were still fresh. That year saw an average of over 1.7 million new homes started, almost a record. Homebuilding activity began to fall after the Fed launched its anti-inflation interest rate increases in March of 2022. With the cost of financing rising and affordability declining, building activity fell more than 20% from the 2021 high to April this year. But in May, the Commerce Department reported an impressive 5.2% jump in new housing starts.
This sudden turn could of course reflect the normal variation in monthly statistics, but especially given its size, it more likely reveals something more fundamental. It certainly could have nothing to do with the Fed’s June decision to pause in its pattern of raising interest rates. Rather it likely shows that people are reaching for real estate to secure the hedge it historically has offered against the ravages of inflation.
When people believe inflation has become endemic, as they seem to, real estate holds two unique allures. First, ownership fixes the price of a critical part of the household budget. Whether a person owns property free and clear or has a mortgage with a reasonably stable interest rate, stabilizing the cost of shelter has an especially welcome effect when the cost of living is otherwise rising rapidly. Second, history shows that real estate values more than keep up with inflation and in most cases outstrip the returns on other forms of investment. During the last great inflation of the 1970s and 1980s for instance, inflation averaged a crushing 6.2% a year on average for two decades. Residential real estate values gained 8.7% a year on average during that stretch of time, fully 2.5 percentage points faster than the rising cost of living. On both counts — stabilizing living costs and procuring an appreciating asset — buying looks attractive even if a person must stretch to shoulder the cost of financing.
These mitigating effects should moderate the adverse impact of high and rising mortgage rates. Life as a consequence will appear less onerous for builders and real estate agents, it will also moderate negative effects for the economy at large. Welcome as this influence is, however, the inflation expectations underlying this drive for a real estate hedge carries its own unrelated ill economic effect.
These inflation expectations will impart a momentum to actual inflation, giving it a kind of life of its own. In addition to improving the appeal of home ownership, generally held inflation expectations will prompt earners to demand wage hikes in anticipation of future price increases. At the same time, those generally held expectations will prompt managers to grant such demands on the assumption that they will be able to compensate the bottom line by easily raising prices. The momentum that this behavior imparts to inflation makes the Fed’s job of countering inflation that much harder than it would be otherwise.
However hard or easy the Fed’s job, the existence of these crosscurrents should catch residential building and buying activity in a kind of stasis for the time being. On the one hand, the Fed’s determination to bring inflation back to its 2% target will impel monetary policy makers to keep interest rates, including mortgage rates, high for the foreseeable future and, given Fed Chairman Powell’s recent remarks, probably raise them still higher in the months to come. Those actions will put buying and building activity under downward pressure. At the same time, the allure of home ownership as a hedge, despite increased financing costs, will provide buying and building an upward push. Activity in residential real estate will accordingly suffer little further correction but no recovery and instead bounce around today’s reduced levels for the foreseeable future.
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