Lower Rates Do Not Improve Housing Affordability: US Federal Reserve

Think lower rates are the path to affordable housing? The US Federal Reserve (the Fed) believes you may have been grossly misinformed on that narrative. New research from the Dallas branch the Fed tackles the impact of interest rates on housing affordability. They warn the common belief that lower rates improve affordability is based on the belief low rates have no impact on demand and thus price. That’s absolutely incorrect, as many noticed when cuts were made in 2020 that turned the housing market into a frenzy. 

Housing Affordability Isn’t Just Mortgage Rates, It’s Also About Price

Affordability is most often referred to as the share of income required to service a mortgage. To illustrate the current discussion, they use the Realtor Housing Affordability Index (HAI)—an index based on the share of income a median household would need to spend on a median home. These are indexed values where affordability improves as the numbers get higher, and housing gets less affordable as the values fall. 

Source: Dallas Fed.

Mortgage rates played a big part in recent history. After the Global Financial Crisis (GFC), interest rates were slashed to nearly zero to help boost demand. It helped housing become the most affordable it may have ever been. Though it’s important to note that post-2020, affordability starts to plummet with interest rates.  

“We emphasize that housing affordability not only depends on mortgage rates but also on house prices, which have competing effects,” explains the researchers.

Adding, “…lower interest rates do not necessarily improve housing affordability.”  

Housing Affordability Would Have Gotten Worse Without Rate Hikes

The Fed has been increasingly hearing that housing affordability would not be impacted had they not raised rates in early 2022. They argue that’s simply not true, since that ignores the impact of low rates on home prices.   

It takes roughly two-years for monetary policy changes to be reflected in the market. They note that Previous research shows a 1 point increase in short-term interest rates lowers home prices 7.5% over that period. Had interest rates not climbed they warn, “…house prices would have risen faster, lowering housing affordability. ”

Source: Dallas Fed.

In the above chart, they model two counterfactuals (alternative scenarios) against reality. The first is called the “Naive” counterfactual, which is the assumption most share, where rates aren’t hiked and affordability just continues to move sideways. 

The Counterfactual HAI includes the influence of low rates in creating excess demand. Even without hiking rates, there’s an erosion of affordability due to prices scaling faster than incomes. 

“In the absence of rate hikes, affordability would have still declined after 2022,” they explain. 

Low Rates Will Stimulate Demand, Slow Affordability Improvements

Raising rates wouldn’t have prevented an erosion of affordability, but neither will cutting them early. In fact, they model income and home prices to show the impact. The following is a baseline forecast, where home prices and incomes move at the current rate. It’s presented along with a scenario where rate cuts lower interest cost, but also stimulate demand. 

Source: Dallas Fed.

The above models show affordability improving steadily in the baseline scenario. In the alternative, affordability improvements slow as rates are cut to provide stimulus. The influence of low rates on demand and increased credit capacity have the opposite effect when it comes to housing affordability. 

“Changes in monetary policy directly affect mortgage rates, but there is also an indirect effect on house prices. When monetary policy is easier, mortgage rates tend to fall, while house prices tend to rise due to higher demand. These opposing channels imply that the net effect on affordability is ambiguous and potentially the opposite of what intuition based solely on mortgage rates would suggest.” 

In plain english, low rates don’t always provide more affordability unless the rest of the context is given. During the Financial Crisis, low rates occurred while home prices were falling. While it boosted demand, the speculative nature of the market had already been eliminated. 

The Federal Reserve isn’t the only central bank to warn low rates don’t always improve affordability. Just a few years ago, the Bank of Canada (BoC) explained to analysts that low rates historically haven’t improved affordability. They previously assumed lower rates reduce interest costs, thus reducing payment size. Not what happened—it stimulated demand and the increased credit capacity helped absorb rising prices more easily, accelerating growth. Whoops!