Is the US housing boom a cause for concern?

The National Association of Realtors reported that the median sale price of an existing home reached $329,100 in March 2021 (an increase of 17.2 percent year-over-year). According to Redfin, the average sale-to-list price ratio, which reflects how close the selling prices of homes are to their asking prices, reached an all-time high of 101 percent, and almost half of the houses (around 46 percent) were snapped up within a week of being put on the market. Clearly, the single-family housing market is seeing a historic boom. Some are wondering if we are in the midst of a housing bubble that may ultimately crash and adversely affect the broader economy.

Several factors are driving the extraordinary surge in home prices. Mortgage rates fell to historic lows in 2020 on the back of aggressive actions by the Federal Reserve (Fed). After lowering short-term policy rates to near-zero levels, the Fed has engaged in large-scale asset purchases to reduce long-term borrowing costs. After a brief spike in February and March of 2021 (driven by an uptick in the benchmark 10-year Treasury yield), mortgage rates fell back in April and remain relatively low. Clearly, ultra-accommodative monetary policy has enabled the surge in housing demand. 

Besides low mortgage rates, the perceived role of housing as a long-term hedge against inflation is also influencing demand. Well-off investors are purchasing secondary properties and vacation homes as they seek to diversify their asset holdings in light of the Fed’s more sanguine approach to dealing with inflation. A top Fed official recently noted that the central bank will hold off on raising policy rates from their near-zero levels until “inflation has risen to 2 percent and other complementary conditions, consistent with achieving this goal on a sustained basis, have also been met.” 

Structural forces are also responsible for the spike in housing demand. On the demographic front, the millennial generation (now a bigger cohort than the baby boomers) is finally shedding its image as the“renter generation” and seeking home ownership. Another factor that might have lasting consequences is the pandemic-induced shift in buyer preferences. The emergence of the work-from-home trend (along with a shift in corporate attitudes towards remote work) and the growing desire to escape dense urban environments has led many to seek out more living space and created a surge in demand for single-family homes in the suburbs.

On the supply front, a significant shortfall in single-family housing has emerged over the past decade. Following the collapse of the housing bubble during the 2006-08 period, the construction industry shifted its focus towards apartment building and away from single-family units. This led to a single-family housing deficit of around 3.8 million homes by the end of 2020, according to Freddie Mac. 

Recently, severe housing supply constraints have emerged. Surging lumber prices, limited availability of land for development and a shortage of construction workers have all created the perfect storm for builders and limited the supply of new housing. Furthermore, record low inventory of existing homes on sale has compounded the problem. The combination of heightened hesitancy among potential sellers and a growing number of eager buyers has created a recipe for massive spikes in home prices.

The discussion so far has highlighted multiple factors responsible for the growing supply-demand mismatch in housing and the resultant double-digit year-over-year surge in home prices. From a macroeconomic and policy standpoint, the critical question is the following: Does the current environment constitute a housing bubble and should we be worried of a near-term housing shock that can potentially derail what appears to be a robust U.S. economic recovery?

Robert Shiller and Karl Case, in their prescient 2003 study, observed: “During a housing price bubble, homebuyers think that a home that they would normally consider too expensive for them is now an acceptable purchase because they will be compensated by significant further price increases. … First-time homebuyers may also worry during a housing bubble that if they do not buy now, they will not be able to afford a home later. Furthermore, the expectation of large price increases may have a strong impact on demand if people think that home prices are very unlikely to fall, and certainly not likely to fall for long, so that there is little perceived risk associated with an investment in a home.” 

While skyrocketing prices and desperate buyers might give the impression that we are in a housing bubble, it is worth emphasizing that the underlying trends are not being driven by a lowering of lending standards or by widespread speculation. Instead, a confluence of structural forces, limited supply and low mortgage rates have led to the current housing boom. In the short-run, the real risk is associated with a sudden cooling of housing demand just as construction kicks into high gear. This scenario is likely to be caused by a sharp rise in mortgage rates, which in turn may be driven by a pick-up in inflation expectations and a spike in long-term Treasury yields.

Longer term, further widening of the gulf between the haves and have nots appears inevitable. Those whose jobs and earnings were left largely unaffected by the pandemic (and whose wealth rose sharply over the past year due to surging asset prices) are best positioned to benefit from the current market environment. Meanwhile, the less fortunate and those who were worst affected by the pandemic shock will face further delays in their quest for home ownership.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.