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[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]

That’s probably right. I hope that’s right. But if I were an investor in the derivatives market, I don’t think this is the moment that I would be looking to increase my share of MBS, even though the assets themselves are of much higher quality than in 2008. The fact that the Fed picked up a third of its portfolio during the pandemic and the exuberance would have me wondering what the market in MBS will look like without the Fed propping up a third of it. And if the sell off doesn’t go smoothly, a nimble course reversal might not be as possible as it otherwise would be given how much of the market the Fed is holding. As I’ve said before, it could actually be fine, as you suggest, but it definitely feels like uncharted territory. It’s not clear what a normal post-pandemic MBS market looks like. [/quote]

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