The Weekly Tearsheet: Housing affordability in the US.

The consumer price index showed that inflation continues to moderate. Prices rose 0.2% month-over-month and 3.2% year-over-year. Shelter accounted for 90% of the increase in the CPI. If you strip away food and energy, inflation rose 0.2% month-over-month and 4.7% year-over-year.

Below is a chart of the year-over-year increases in the consumer price index for shelter and the year-over-year changes in the FHFA House Price Index. The super-high increases in the index are pretty much over, and we should see a moderation in the index for shelter over the next year.

While transactions in the real estate market are moribund, bidding wars are still a feature of the landscape as the inventory of homes for sale is incredibly low. There is a bit of a catch-up going on now, where MSAs which missed out on the big post-bubble rebound start to get bid up. This is particularly noticeable in the Midwest and the Northeast.

The affordability issue has created a bit of a pickle for policy-makers. What is the the thorn in people’s sides these days, especially the young? Housing costs. It is typically one’s biggest expense, and rents have been moving up at a decent clip. You can see in the chart above we had a couple years of high teens appreciation in the real estate market. Housing affordability is back at at levels last seen during the bubble years, according to the Atlanta Fed’s Home Affordability Index.

This is not good news for policy makers. The Fed is in a real bind, because the big issue with affordability is rates, not prices. The Fed could cut rates, which would help on the interest rate front, but might trigger a further rally in real estate prices, and real estate prices relative to incomes are looking very stretched. According to NAR, the median home price is around 416,000, while the median household income is around 74k. This means the median price to income ratio is 5.6x, which is very elevated. This is way more than during the bubble years.

When the ratio started creeping up in the 2017-2020 years, you at least had the benefit of low mortgage rates which helped offset the issue. Not any more. With rates at 22 year highs, that excuse goes away. One big difference between the bubble years and today is inventory, which is estimated to be about a quarter of what it was in 2007. Housing construction has punched below its weight for 15 years.

So what do you do as a policy-maker? If you are the Fed, you really are in a no-win situation. Raise rates and make homes even more unaffordable, or cut rates and watch home price appreciation accelerate. The Fed is going to stick to its knitting and get core inflation down to the 2% target and housing affordability will have to continue to suffer.

Legislatively there aren’t a lot of levers to pull. The left will go to its old reliable Rx, which is encouraging affordable housing construction. The problem is that that we don’t seem to have an issue with apartment construction - apartment units under construction are at record levels. Certainly office buildings can be converted to multi-use, but apartments aren’t the problem, single family units are. The left’s panacea is zoning reform to allow multi-fam construction in single family zoning, but that is a tough nut to crack, even in deep blue areas in deep blue states. The Obama Administration picked a fight with Westchester County NY, a NYC suburb, and only managed to negotiate some 700 units of affordable housing construction over 8 years. Westchester County has a long and distinguished history of giving NYC, Albany, and DC the Heisman over the past 50 years regarding zoning and affordable housing.

We still continue to hear talk about skilled labor shortages as the bottleneck. I suspect that will get fixed on its own. More and more men are skipping college these days for the trades, and they can make quite a lot in construction. The compensation is high enough, and they don’t graduate with hundreds of thousands of dollars in student loan debt. Land should be less of an issue, as work-from-home has made the exurbs more feasible for new construction.

Despite the good news on inflation, bond yields remain stubbornly high. The 10 year bond yield seems determined to test the highs of last October, where rates peaked around 4.23%. Part of the reason may simply be that the consensus in the markets is that the Fed will manage to avoid a hard landing, which means the yield curve should be less inverted. Since the beginning of August, the 2s-10s spread has decreased to -77 basis points. The 2 year has been flat over this time, so the driver has been the 10 year.

I suspect rates will work their way lower as China’s economy implodes over its real estate bubble. Remember the price to median income ratio I talked about above? Where 5.6 is an all-time high for US real estate prices. In Beijing, the ratio of median price to median income is around 47x. That would equate to a median house price in the US of $3.5 million. China’s biggest private developer appears that it will default on a couple of its bond issues, and sentiment in the Chinese property sector is reportedly terrible.

I still think that the Chinese implosion will send a deflationary shock wave through the global economy, which will push down inflation and possibly asset prices. The Chinese probably don’t have much in the way of policy levers they can use aside from forbidding sales transactions (which is how Japan did it), and once real estate bubbles burst, they take on a life of their own. In the meantime, the Fed is making progress on inflation, and will probably be able to pause rate hikes for a while, thus sucking out some of the elevated rate volatility we have seen over the past year. That will go a long way towards pushing mortgage rates lower and improving the lousy affordability picture.