About the Author: Daryl Fairweather is Chief Economist at Redfin and former Senior Economist at Amazon.
Imagine an island ruled by a benevolent queen. When a famine threatens the prosperity of the island, the queen uses her power to save the economy. That 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 the economy while minimizing the harm done to her fellow citizens during the transition?
This fable can help us understand the predicament of the Fed when it comes to unwinding the $2.66 trillion in mortgage-backed securities portfolio it amassed while saving the real estate market from crashing in 2009 and preventing a possible crash in 2020. Like the queen in our fable, the Fed faces tough choices about how to withdraw its extraordinary intervention in the economy. Housing prices have soared during the pandemic, 30% increase in just two years. The Fed has the power to raise mortgage rates, which would lead to lower growth in house prices and sales. But if the Fed continues to provide cheap debt to the housing market and the broader economy, inflation could outpace investment returns and make it hard for bankers to profit. Unfortunately, there is no “neutral” way to act without tacitly helping some more than others, as the fable will show.
A fable to understand the Fed
Back to our island. Our story begins when the High Priestess warns the Queen that her people are in grave danger. She has seen from the stars that most of the fish that normally migrate to the island reef will not come this winter, but will instead migrate to nearby reefs. In a normal winter, some fishermen use boats, while others hunt offshore. If the prophecy is true, all fishermen will need boats to ensure a sufficient harvest of fish. The queen is distraught as fish make up half of the islanders’ diet and a failure of the fish harvest would cause famine.
The queen visits the banker on the island and offers to lend him as much money as he wants without interest. “I’ll be happy to borrow money from you without interest,” replies the banker. “But I won’t lend money to people who want to buy boats. Your High Priestess says the fish will not approach our reef and the journey to nearby reefs may be perilous. It’s not good business to lend money to fishermen who may never come back.
So the queen needs a new plan. It allows the banker to borrow royal money, interest-free, to grant loans to coconut farmers. If the fish harvest is lacking, the village will need more coconuts. Unfortunately, the coconut harvest will only take place in the spring and many islanders will starve without the winter fish harvest. So the queen decides to lend directly to the fishermen.
Because the queen offers almost interest-free loans, the islanders rush to buy all the available boats, causing prices to spike. Some wealthy islanders buy boats and leave them on the dock all winter. But luckily, the fishermen set sail for the nearby reefs. They all return, thanks to favorable weather, with just enough fish to avoid starvation.
The following fall, the island’s banker pleaded, “Dear Queen, I appreciate the interest-free loans you have given me, but there are only a limited number of coconuts that can be harvested. profitably on our island. I used to make half my money lending to fishermen, but I can’t compete with your boat loans and make a profit. So I’m begging you, please stop lending the islanders money to buy boats.
The queen never liked to loan boats. Loans are complicated because there are a variety of boats that are better or worse for different types of fishing, and she doesn’t like the number of boats bought to just sit at the dock. The Queen is also concerned about the loans the banker is currently making – she has noticed the islanders borrowing money to speculate on the prices of rare pearls instead of working as coconut harvesters. The queen therefore agrees to stop lending on condition that the banker starts paying interest again.
The next day, a young fisherman visits the queen. ‘Dear Queen,’ he pleads, ‘I had intended to use one of your royal loans to buy my captain’s boat when he retires this year, but I cannot pay the interest that the banker demands.”
The queen is confused. “Why doesn’t your captain just sell you his boat at a lower price?” she asks. “If you can’t afford his boat, he probably doesn’t have any other buyers waiting either.”
“My captain will only sell if I pay the price I offered last week,” says the young fisherman. “He prefers to rent the boat to me and wait for the price of the boats to go 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, as 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 one day leave to my children, so that they don’t have to grow up like me as farmers. Without Royal Loan, I can’t do any of this.
So what should the queen do? The queen must decide who to favor: the borrower or the banker. The queen would like to stop making loans and sell the loans she has to the banker. She feels uncomfortable having so much influence in the boat market. But if she stops lending, the Queen could prevent the next generation of fishermen from building intergenerational wealth.
The queen decides to make a proclamation. She will make 10% less boat loans each year in order to slowly bring her island’s economy back to normal. The banker is unhappy that the queen keeps lending faster, but the young fisherman is happy to have 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 situation similar to that of the Queen and must decide who to favor, the borrower or the banker. The Fed would like to exit the MBS market. It only intervened in 2020 to ensure stability in the housing market, but now the demand for housing is far away to go past to supply. Investment bankers made it clear that they wanted the Fed to stop buying MBS and get inflation under control. Like the island banker, investment bankers worry that there is too much money for unprofitable investments. If true, it could cause runaway inflation or asset bubbles. However, as the Fed scales back its purchases of MBS and raises the federal funds rate, every potential homeowner who hasn’t been 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: purchases of second homes have doubled and luxury home sales growth quadrupled in 2020. It’s unfortunate that, just as many Americans are getting back on their feet, the Fed will make homeownership less accessible, but it can at least soften the blow by moving slowly. If the Fed acts too quickly, housing demand could disappear, homebuilders could stop building new homes, and we could see another decade of record home construction when America is already runs over 5 million homes.
economists expect 30-year fixed mortgage rates to rise to 4.3% by the end of the year. We expect home sales to decline 5% by the end of 2022 and price growth to fall to 5%. This assumes a slow reduction in the Fed’s MBS portfolio. It also assumes that owners (like the captain of the boat) will avoid selling in a market weakened by higher mortgage rates, especially when rental demand remains high.
We think the Fed will want to avoid moving too quickly because sending rates higher than pre-pandemic levels would make buying a home too expensive and not lucrative enough for potential sellers or builders. It could even make home ownership less accessible to the middle class and could contribute to increasing wealth inequality. Because the Fed recently pointed out the negative effects of growing wealth inequality on the economy as a whole, I think it will prioritize the welfare of the borrower over that of the banker. This means that the Fed will continue to buy MBS, but will slow its pace. Over time, the Fed’s MBS portfolio will gradually shrink as the underlying mortgages are paid off. I’m sure the Fed, like the Queen, wants to be able to stay neutral, but that’s impossible now.
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