The Economy Is Going Great, Except For One Huge Problem

Key Takeaways

• High prices and mortgage rates have crushed the housing market, even as other parts of the economy have prospered.
• A long-standing housing shortage has contributed to the housing crunch, alongside the Federal Reserve's anti-inflation rate hikes, which drove up mortgage rates.
• Mortgage rates could ease next year, improving the outlook but not necessarily solving the underlying problems.

Amid a recent spate of data showing the economy humming along smoothly, one sector has consistently stayed out of whack and it’s a big one: housing.

On Thursday, a report from the Bureau of Economic Analysis showed rising housing costs have helped core inflation run higher than the Federal Reserve’s target 2% annual rate. A drop-off in homebuilding in the third quarter was a drag on the economy’s overall growth rate, according to a report from the bureau on the Gross Domestic Product Wednesday. Earlier in the month, data showed homebuilding languished and sales of existing houses skidded to their lowest in more than a decade in September.

The beleaguered housing market is a stark contrast to other important pillars of the economy, which are running relatively smoothly: the job market is holding on to an extended winning streak, consumers are spending freely, and inflation is falling.

At the heart of the problem is the fact that high prices and high mortgage rates have pushed the cost of buying a house out of reach for people with typical incomes who previously could afford the payments. A mortgage payment on the typical newly bought home would take up 42% of a household's median income in August, up from 29% in January 2020, according to a housing affordability monitor created by the Federal Reserve Bank of Atlanta. 

Housing problems are wreaking havoc on the overall economy, hurting family budgets and preventing people from moving to take advantage of job opportunities, among other ripple effects.

High Mortgage Rates Hurt Budgets

The housing market has been collateral damage in the Federal Reserve’s war on inflation.

“When the Fed raises interest rates, it hits the housing industry hardest because It's the most interest rate sensitive sector,” Bill Adams, chief economist at Comerica Bank, said in an interview with Investopedia.

Mortgage rates hit record lows during the pandemic, as the Fed held its influential benchmark interest rate near zero to boost the economy. But when the Fed raised rates rapidly in 2022 to combat inflation, mortgage rates surged. By October 2023, the average rate offered for a 30-year mortgage hit a two-decade high of 7.79%, up from the record low of 2.65% in January 2021, according to Freddie Mac. 

The whiplash virtually paralyzed the housing market, as homeowners who secured ultra-low rates during the pandemic hesitated to sell their homes and exchange them for new mortgages at higher rates.

As a result of that “lock-in” effect, there are far fewer homes on the market than before the pandemic, according to the National Association of Realtors. And homebuilders haven’t been keeping up with the demand for new homes, partly because local zoning regulations restrict the construction of new houses where they’re most in demand. And on top of that, demand for bigger homes surged during the pandemic as workers adjusted to the new telecommuting lifestyle.

“You've had this huge step change in the amount of living space that Americans want since the pandemic because so many more Americans work from home now or work from home on some days,” Adams said. “Demand for living space in the United States is just permanently higher than it was pre-pandemic. It’s the flip side of all those empty offices in big city downtowns.”

All those forces have combined to keep prices repeatedly hitting record highs even though many buyers have been priced out of the market.

What's Next?

One part of that equation—mortgage rates—could improve in the near future.

The Federal Reserve cut the fed funds rate from a two-decade high in September and plans further rate cuts in the coming months as inflation simmers down to its target of a 2% annual rate. While mortgage rates don’t always move in tandem with the fed funds rate, they are influenced by it. Forecasters at Fannie Mae expect mortgage rates to drop to the mid-5% range by the end of next year, compared to 6.72% as of last week.

“2024 was a really tough year for the housing market,” Adams said. “2025 should be a better year because the Fed is cutting.”

However, that outlook could be shifted depending on which party wins Tuesday's general election. Both presidential candidates have touted plans to ease the housing shortage, with Vice President Kamala Harris promising to build 3 million affordable homes and former president Donald Trump pledging to free up homes by deporting immigrants.

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