Why There is No Direct Correlation Between Interest Rates and Housing Prices
It appears that one of the most difficult things for many to understand is that there is no direct correlation between interest rates and housing prices. Every time I write that I expect housing prices to go up AND interest rates to go up, I receive emails along this line or see similar comments at various posts:
I am confused about your call that now is a good time to lock in on a 30year mortgage. I am wanting interest rates to go up, believing that it will drive home prices down. Am I wrong in this assumption?
Put simply, there is no direct correlation between housing prices and interest rates. Think about it. If there was a direct correlation, housing prices would be soaring now, given how low interest rates are.
What is important to understand is that the interest rate is composed of many factors. In the market, the rate is adjusted for risk, for the anticipated price inflation rate and, at the core, for the supply and demand point where the time preference for money crosses. In addition to these factors, the Federal Reserve is in the market manipulating interest rates.
In the near future there is a very strong possibility that the interest rate is likely to climb because of escalating price inflation. The Federal Reserve has enlarged its balance sheet by a tremendous amount, with approximately 1.5 trillion dollars ending up in excess reserves. If banks start to loan this out, as Jamie Dimon, Fed President Charles Plosser and I suspect, the first result will be new money in the system. This new money will push up housing prices. As housing prices start to climb, bidders will start bidding up mortgage rates, as the rates go up, though, even more money will come out of excess reserves (Remember, there is approximately $1.5 trillion in excess reserves, that is a huge amount of money—never mind the money multiplier effect). This money pouring out of excess reserves is what Plosser expects and accompanying inflation (including, I believe, housing prices):
Inflation is going to occur when excess reserves of this huge balance sheet begin to flow outside into the real economy. I can’t tell you when that’s going to happen.
When that does begin if we don’t engage in a fairly aggressive and effective policy of preventing that from happening, there’s no question in my mind that that will lead to lots of inflation.
So something like this could occur: Housing prices could climb, by say, 10%. If the Fed wasn’t manipulating things, this would result in a price inflation premium of 10% on top of the time preference rate, in total thus a rate of around 13% (ignoring risk premium, since it doesn’t advance the point I am making). This would stop the manipulated boom. But because the Fed is manipulating rates and there’s a trillion and a half in excess reserves that start leaking out, there is downward pressure on rates, so instead of them climbing to 13%, they may climb only to 7%. So you have prices climbing by 10%, with interest rates climbing to only 7%, which causes more people to bid housing prices even higher, causing more housing inflation, which causes more money flowing out of excess reserves and interest rates climbing, but because of the new flow of money out of excess reserves, interest rates don’t climb high enough to halt the manipulated housing booms. In other words, it’s interest rates relative to where they should be rather than a simple increase in interest rates that is the key force behind climbing housing prices. If interest rates were not manipulated, then rates would climb high enough to put a kibosh on the housing boom, but the Fed is all about keeping rates lower than they should be.
So while I expect rates to climb significantly, say to 7% as a first stop, I expect housing prices to climb by 10% at such time and keep the manipulated boom going.