Fed Rate Cuts: Unintended Consequences for the Housing Market

New York — CNN

In recent years, the US economy has managed to curb inflation across various sectors, but the housing market remains stubbornly stuck with high prices and a persistent lack of supply. The Federal Reserve’s anticipated rate cuts could theoretically help alleviate the home affordability crisis, but they might also inadvertently worsen it. Here’s a breakdown of the situation.

At the heart of the housing market issue is a classic supply and demand imbalance: there are more buyers than available homes. This imbalance was pronounced even before the pandemic spiked demand, and the market has become increasingly strained as mortgage rates soared from historic lows in 2020 to their highest levels in a generation last year.

When the Federal Reserve begins cutting rates, likely starting Wednesday, it is expected to have a liberating effect on the market. However, the impact largely hinges on how aggressively the Fed reduces borrowing costs.

A significant rate cut — though not guaranteed — could signal the Fed's commitment to countering the “lock-in” effect, where homeowners with low-rate mortgages are reluctant to sell in a high-rate environment. An aggressive reduction could lower financing costs, increase the inventory of existing homes, and potentially ease home prices.

Daniel Alpert, managing partner at Westwood Capital, suggests that this could be beneficial in the current cycle. Lowering owner-occupied housing costs might encourage people to leave the rental market, thereby reducing rents — a scenario Alpert describes as “Goldilocks.”

However, if the Fed opts for a more gradual reduction, it might not sufficiently motivate homeowners, particularly those with favorable early-pandemic mortgage rates, to sell. With home prices still at record highs, the effect on supply might be limited.

Although the Fed can’t directly build houses, it can influence the housing market by affecting mortgage rates. Recent anticipation of a rate cut has already nudged mortgage rates down to 6.2% from 6.7% earlier in August. If the Fed adopts a more dovish stance, rates might drop to around 6% or even 5.9%, potentially having a psychological impact on the housing market.

Daryl Fairweather, chief economist at Redfin, notes that while a drop to 5.9% would not fully restore pre-pandemic inventory levels, it could motivate many potential buyers to act. With the current 6.2% rate being an improvement over last year’s peak of 7.8%, even small reductions could translate into significant savings for homebuyers.

Yet, the Fed’s actions could have unintended consequences. If demand increases without a corresponding boost in supply, the affordability issue might become even more pronounced. As Greg McBride, chief financial analyst at Bankrate, puts it, “A further drop in mortgage rates could spur a surge in demand, making it even harder to buy a house.”

In summary, while Fed rate cuts could provide some relief, they may also lead to new challenges in the housing market, especially if supply issues are not addressed alongside demand.