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[quote=Anonymous][quote=Anonymous][quote=Anonymous][quote=Anonymous][quote=Anonymous][quote=Anonymous]The most likely scenario for close-in desirable DC neighborhoods is that nominal prices may stagnate—not fall and certainly not crash—over the next few years. They will fall, however, in real terms. [/quote]

This person is getting closer to the truth. I don't actually think real prices will fall; it's more likely that appreciation will gradually slow over the next year and then that real prices will stay flat for a few years. Nominal home prices will almost certainly not fall. But this PP is right; if you're not thinking about how inflation works in this scenario, you're not taking the question seriously.

Inflation is 7%, which means that real interest rates are still quite negative (you can pay 5% interest to buy a typical asset now or you can hold cash for a year for the privilege of paying 7% more for the same asset). So, even with factoring in for some depreciation, it still makes sense to borrow heavily in order to purchase durable assets for which the new value will appreciate at or above the rate of inflation. In fact, because inflation has risen faster than interest rates, real interest rates are now quite a bit lower than they were at the beginning of the pandemic.

Of course, inflation probably won't stay this high, since some of the supply shock issues associated with the pandemic will start to abate and since interest rates are rising quickly. Housing averages about 30% of household expenditure and so it makes up about 30% of CPI, although it's calculated based on imputed rent, not on home prices themselves. But, for that reason, it's difficult for the cost of housing and inflation indicators to diverge greatly for very long. If the inflation rate falls significantly, then by construction the rate of home price appreciation is almost certainly falling, and vice versa.

To the extent that the Fed controls interest rates indirectly, they want to slow down home price appreciation because they want to rein in inflation overall. But they also really don't want nominal home prices to fall, because that can set off a very costly credit market spiral as in 2008. Since the Fed's toolkit has been greatly expanded to include rapid asset purchases, they can basically guarantee that even if they overshoot on interest rates, nominal home prices won't fall substantially at a national level. The potential cost of this kind of backstop is that they may not be able to bring down overall inflation as much as they would like to. So, you would end up with something more akin to the stagflation of the 1970s; very high interest rates yielding low economic growth, but still substantial inflation. No fall in nominal home prices, though.

The more likely scenario is that we don't hit any such backstop. Inflation falls due to rising interest rates, and real home price appreciation falls with it. Since durable goods like houses are more sensitive to changes in interest rates than non-durables, real home prices fall. But nominal home prices don't fall. If they started to, then the Fed would just resume asset purchases to backstop the credit markets. Guaranteed asset purchases are a much faster acting tool than interest rates, so even though the Fed's interest rate hikes course through the economy over months, the backstop is pretty firm.

It's also still very possible that the Fed engineers a "soft landing." If interest rates don't rise too quickly, then real home prices could stay flat or even rise slowly. This is what a return to 2% inflation and 3% home appreciation would look like. Modern monetary policy hasn't operated in the aftermath of a pandemic before, so it's hard to know how well some of the Fed's decisions will play out in this regard. But, this is the outcome that the Fed is currently aiming for.

So, is it possible that your house could be a relatively poor investment over some period of time? Sure (although you also need to take into account imputed rent, leverage, and favorable tax treatments to do that comparison). But it's still very unlikely that home prices will fall in nominal terms, which means that getting stuck with an underwater mortgage or being unable to sell your house is still not something that you should be concerned about.

PS: The person claiming that the market will drop 20% in the next three weeks, the person comparing other posters to Putin for disagreeing, the person posting in mIxEd CaSE, these are not serious people.[/quote]

Question just for this PP only: talk to me about what you think about the Fed’s planned sell off of its unusually large MBS portfolio. The size of the portfolio seems like a nontrivial variable, but you didn’t mention it. Do you believe it’s a non-issue? As you note, they can always change course and start buying again, if they find they have over-corrected with interest rates, but isn’t there a risk that the portfolio is already so large they don’t actually have much room to go in that direction? The Fed can’t realistically hold much more than the 30% of the market it already holds without introducing other problems into the equation. And it is something of a question mark how the MBS market will respond to the initial sell off. I’d be interested to know what you think. [/quote]

We have had a decade of strict mortgage rules, those MBS are probably fairly high quality now and will find a good market. Rates will likely go up some as alternatives are paying more, but the MBS will find a ready market. [/quote]

I'm the PP (this poster is not, for clarification). I agree that the quality of the MBS is not a huge concern. In 2008, there was uncertainty about contagion from things like credit default swaps and other linkages that the market couldn't easily observe. None of those features apply to the Fed, and the size of the Fed in the market means that every other individual player is less likely to be big enough to freeze up the market. That's not the whole story, but it is one important necessary component of maintaining a liquid market.

I think of the Fed's actions as operating on the risk-return frontier of the MBS market. If the Fed becomes an even larger player in MBS, they bid up the price of those assets and make the market less risky (opportunity costs, not default risk of the underlying mortgages) in exchange for lower expected returns. There is no inherent reason why this mechanism can't operate right up to the point of the Fed controlling virtually all of the MBS market, as long as its actions are predictable.

Unpredictability of the Fed's objective function would be a problem. For example, if a very large Fed tried to bully private buyers using its market power, it could theoretically cause the private MBS market to collapse. I don't see how or why this would ever happen because it's clearly not in the interest of the Fed itself. The bigger potential downside to a very large Fed presence in MBS is that the bigger the market share, the more limited is the Fed's ability to sell assets to control inflation without tanking the private MBS market. Eliminating that tool from the toolbox could make it harder to keep inflation in check; they would need to use higher interest rates instead. But the issues with the Fed's market power are asymmetric. No matter its portfolio size, the Fed can always buy more assets without destabilizing the market, so the backstop on nominal prices isn't threatened.

In any case, the Fed has moved pretty deliberately and with lots of advance notice so far. So, I'm inclined to think that any effect that their current or expected future portfolio size has is priced into the market, much as a good portion of the planned interest rate hikes are priced into current rates. I think we're very far from having to worry about the Fed disrupting the function of the private market.[/quote]

This is helpful and reassuring. I do have some doubt about whether the Fed is capable of controlling too much of the secondary market. The Fed isn't an ordinary market participant. I don't think the Fed can hold much more of the market than it already owns without a significant disruption. I may be underestimating the capacity for adaptation, but I think that the private secondary market still plays a vital role in the overall health and equilibrium of the system, and if the Fed continues to grow its market share, at some point there will cease to be a functional private market. But I also agree that we are not there yet. I think the Fed is already close to edge of what the secondary market is prepared to tolerate and therefore it has a less than ideal amount of room to maneuver during this delicate transition time, as it tries to move away from its pandemic-era portfolio. But I do agree that thus far it's done an excellent job in terms of predictability and signaling. Maybe that, coupled with the quality of the underlying assets (although I will reserve some concern about exuberance borrowing behavior as we head into an market slow down) will make the Fed's sell off a nonissue. [/quote]

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