Why the Fed is taking a hammer to the housing market

The Federal Reserve's rapid interest rate hikes are taking a serious toll on the housing market. Home prices and sales have fallen throughout the year as buyers recoil from rising mortgage interest rates — one of the first sectors of the economy affected by Fed rate hikes.

As the Fed boosts its baseline interest rate range, borrowing costs for consumers and businesses rise along the way. The average rate for a 30-year fixed-rate mortgage rose to 5.3 percent at the end of last week, according to Freddie Mac, up from 3.1 percent at the start of the year.

While mortgage rates have fallen slightly since peaking in the wake of the Fed's June rate hike, the sharp increase in interest rates has already taken a hammer to what had been a historically hot housing market.

"The recent decline in affordability has been driven largely by higher mortgage rates. This stands in contrast with last year, when higher home prices were the main driver," wrote Goldman Sachs economist Vinay Viswanathan in a Friday research note.

Housing prices and sales rose at double-digit rates in 2020 as a result of near-zero Fed interest rates, trillions of dollars in fiscal stimulus and months of pandemic-related lockdowns that drove a surge of homebuying.

Sales slowed slightly in 2021 under the weight of higher prices, but a severe shortage of homes and the Fed's refusal to raise interest rates helped keep prices high and borrowing costs low for buyers who could keep up with the market.

The Fed is now moving the market in the opposite direction by making it more expensive to buy homes already inflated by years of rapid price increases.

"Housing is an interest rate sensitive sector. As mortgage rates rose over the past couple of months, we saw buyers pull back in response to the higher housing costs," wrote Ali Wolf, chief economist for housing data firm Zonda, in a Friday email.

"Many pundits emphasize home price levels, but ultimately, people buy homes based on the monthly payment. Rising home prices combined with higher mortgage rates are driving up the monthly mortgage payment, which is impacting housing affordability," she wrote.

Wolf said 11 percent of U.S. homebuilders slashed their prices in June from May, according to Zonda data, to help keep up sales. Home sale cancellations also jumped to 14.9 percent in June, according to brokerage firm Redfin, the highest rate since the start of the COVID-19 pandemic.

Slowing the housing market is a tough break for potential sellers, who had hoped to cash in on the steep climb in prices over the past two years. Housing prices are also not included in the inflation rate, so a decline in sale prices will not have a direct impact on the federal government's price growth data.

Even so, the drop-off can play a key role in the Fed's fight against inflation.

As home sales decline, so will the spending on the listing and transaction costs, moving services, furniture, repairs, renovations that come along with buying or selling a house.

Lower home prices may also ease pressure on inflation through what economists call "wealth effects."

Americans with ample income may not be affected by rising interest rates on credit cards, which increase in lockstep with the Fed's baseline interest rate. But the Fed's rate hikes will also reduce their wealth — and perhaps spending — by shrinking the value of their homes, stocks and other financial assets.

American homeowners expect the price of their houses to fall by a median of 5.8 percent over the next year, according to the Federal Reserve of New York's latest Survey of Consumer Expectations, a figure that's down from 4.4 percent in May. The monthly drop was the second largest in the history of the survey, and the expected price decline is the worst since February 2021.

Rising concerns about a recession have also prompted some potential buyers to wait until economic storm clouds pass, Wolf said, while others have been priced out by rising mortgage rates.

"The higher cost of homeownership is pricing some potential buyers out of the market but is also changing the math in the rent-versus-own discussion," she explained. "Many prospective buyers are choosing to sit on the sidelines to wait and see how both the economy and housing market progress before making the decision to purchase."

A steady decline in home prices could help bring down inflation while also making houses more affordable. The U.S. suffered from an affordable housing shortage long before COVID-19 struck, and the pandemic only exacerbated the lack of homes within reach of many first-time buyers.

Fewer buyers means less competition for homes on the market, which could make homes slightly more affordable as the market corrects. But a longer-term lack of construction may leave homebuyers with little relief when the market turns around again.

"The U.S. housing market is undersupplied long-term when looking at population figures, but the market can bounce from undersupplied to oversupplied cyclically. If demand slows enough, builders may find themselves with more homes than buyers that are willing to buy them," Wolf said. "Builders won't want to bring more homes to the market if they aren't sure they will sell them."