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The Fed’s Housing Dilemma: There Is No Way to Be Neutral

Imagine an island ruled by a benevolent queen. When a famine threatens the island’s prosperity, the queen uses her power to save the economy. It works. But before the islanders can live happily ever after, the queen must decide what to do with her power, which she has pledged to use without favor on behalf of all her subjects. How can the queen let go of her reins on the economy while minimizing the harm done to her citizens during the transition?

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This fable can help us understand the Fed’s predicament when it comes to unwinding the $2.66 trillion mortgage-backed securities portfolio that it accumulated while saving the housing market from collapse in 2009 and preventing a potential collapse in 2020. Like the queen in our fable, the Fed faces difficult choices about how to withdraw its extraordinary intervention in the economy. Housing prices have spiked during the pandemic, increasing 30% in just two years. The Fed has the power to increase mortgage rates, which would cause a decline in home-price growth and sales. But if the Fed keeps providing cheap debt to the housing market and broader economy, inflation could outpace returns on investment and make it difficult for bankers to profit. Unfortunately, there’s no “neutral” way to act without tacitly helping some more than others, as the fable will show.

A fable to understand the Fed

Let’s get back to our island. Our story begins when the high priestess warns the queen that her people are in grave danger. She has seen in the stars that most of the fish that normally migrate to the island’s reef will not come this winter, but will instead migrate to neighboring reefs. In a normal winter, some fishermen use boats, while others spearfish off the shores. If the prophecy is true, all of the fishermen will need boats to ensure a sufficient fish harvest. The queen is distraught because fish makes up half of the islanders’ diet, and a bad fish harvest would cause a famine.

The queen visits the island’s banker and offers to loan him as much money as he wants without interest. “I will gladly borrow money from you interest-free,” the banker replies. “But I will not lend money to those who want to purchase boats. Your high priestess says the fish will not come near our reef, and the journey to neighboring reefs can be perilous. It’s not good business to lend money to fishermen who may never return.”

So the queen needs a new plan. She allows the banker to borrow royal money, interest free, to make loans to coconut farmers. If the fish harvest is lacking, the village will need more coconuts. Unfortunately, the coconut harvest won’t happen until spring, and many islanders will starve without the winter fish harvest. So the queen decides to lend directly to the fishermen.

Because the queen is offering nearly interest-free loans, the islanders rush to buy all the available boats, causing prices to surge. Some wealthy islanders buy boats and leave them on the dock all winter. But luckily enough fishermen set sail for the neighboring reefs. They all return, thanks to favorable weather, with just enough fish to avert a famine.

Next fall, the island’s banker pleads, “Dear queen, I appreciate the interest-free loans you have provided me, but there are only so many coconuts that can be profitably harvested on our island. I used to make half of my money lending to fishermen, but I can’t compete against your boat loans and turn a profit. So I implore you, please stop lending money to the islanders to buy boats.”

The queen has never liked making boat loans. Lending is complicated because there are a variety of boats that are better or worse for different kinds of fishing, and she doesn’t like how many boats were bought to only sit at the docks. The queen is also concerned about the loans the banker is currently making—she has noticed islanders borrowing money to speculate on the prices of rare pearls instead of working as coconut harvesters. So the queen agrees to stop lending on the condition that the banker starts paying interest again.

The next day, a young fisherman visits the queen. “Dear queen,” he pleads, “I was planning to use one of your royal loans to buy my captain’s boat when he retires this year, but I can’t afford the interest payments that the banker requires.”

The queen is confused. “Why won’t your captain just sell you his boat for a lower price?” she asks. “If you can’t afford to buy his boat, he probably doesn’t have any other buyers lined up either.”

“My captain will only sell if I pay the price I offered last week,” says the young fisherman. “He would rather rent me the boat and wait for the price of boats to go back up. But if I rent the boat, I will never save enough to buy it. To make matters worse, there are no other boats for sale, because so many people bought boats last year. My captain even bought his 10-year-old daughter a new boat. My dream is to own a boat that I can leave my children one day, so they don’t have to grow up as peasants the way I did. Without a royal loan, I can’t do any of that.”

So what should the queen do? The queen has to decide whom to favor: the borrower or the banker. The queen would like to stop making loans and sell the loans she owns to the banker. She feels uncomfortable having so much influence over the market for boats. But if she stops lending, the queen may prevent the next generation of fishermen from building inter-generational wealth.

The queen decides to make a proclamation. She will make 10% fewer boat loans each year in order to slowly return her island’s economy to normal. The banker is unhappy that the queen isn’t halting lending faster, but the young fisherman is happy he has another chance to borrow money from the queen to buy his captain’s boat this year.

How the Fed’s actions will impact the housing market

The Fed is in a similar predicament to the queen, and has to decide whom to favor, the borrower or the banker. The Fed would like to get out of the MBS market. It only intervened in 2020 to ensure the housing market would remain steady, but now demand for homes is far outpacing supply. Investment bankers have made it clear that they want the Fed to stop buying MBS and get inflation under control. Like the island’s banker, investment bankers are concerned there is too much money chasing unprofitable investments. If true, this could cause runaway inflation or asset bubbles. However, as the Fed winds down its MBS purchases and raises the federal funds rate, every potential homeowner who wasn’t able to lock in a low monthly mortgage payment on a home will have missed their chance.

During the pandemic it has largely been the wealthy who have benefited from cheap debt: second home purchases doubled and luxury home sales growth quadrupled in 2020. It is unfortunate that just as many Americans are getting back on their feet, the Fed will be making homeownership less attainable, but it can at least soften the blow by moving slowly. If the Fed moves too quickly, demand for homes could disappear, home builders could stop constructing new homes, and we could see another decade of record low home construction when America is already short more than 5 million homes.

Redfin economists expect 30-year fixed mortgage rates to increase to 4.3% by the end of the year. We predict home sales to decline 5% by end of 2022 and price growth to fall to 5%. This assumes a slow wind-down of the Fed’s MBS portfolio. It also assumes that homeowners (like the boat captain) will avoid selling into a market weakened by higher mortgage rates, especially when demand for renting remains high.

We believe the Fed will want to avoid moving too quickly because sending rates higher than pre-pandemic levels would make homebuying too expensive and not lucrative enough for potential sellers or homebuilders. This could make homeownership even less accessible to the middle class and could contribute to rising wealth inequality. Because the Fed recently emphasized the detrimental effects of rising wealth inequality on the economy as a whole, I believe it will prioritize the borrower’s wellbeing over that of the banker. That means the Fed will continue to buy MBS, but slow down its pace. In time, the Fed’s MBS portfolio will shrink gradually as the underlying mortgages are paid off. I am certain the Fed, like the queen, wishes it could remain neutral, but that’s impossible now.

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