By Karl Smith
Real life is being insanely intrusive, but I couldn’t go much longer without saying anything.
There is lots of talk about whether we have hit the bottom in inventories. Bill McBride seems to have gone from fairly certain we had to leaning towards no.
My seasonal adjustment (hand tuned) suggested that the rate of inventory decline had not changed significantly in the last two years or so, and that there was no particular reason to think it was changing right now.
Eventually, it has to change because inventory is a countable quantity and hence bound above zero. The question is how and why will it change. The typical answer is increases in supply or decreases in demand.
Note, however, that supply must mean vacant homes being listed for sale or new homes being built. Underwater home owners “waiting for a better market” cannot increase the actual supply of homes when they go to sell, because presumably, they will be moving into some other home.
They can reduce demand if they move in with relatives because then they will contribute to a decrease in the total number of households.
So, with few vacant homes and few new homes under construction, we would expect this inventory decline to be choked off by a decline in demand. This usually occurs because rising prices decrease buyer interest.
Prices And Housing Demand
Housing demand is strange, however, because the total demand for houses is not solely or even primarily price rationed, in the way most goods and services are. Total house demand is largely credit rationed.
That is, what stops a family from buying a house, at all, is often that they could not qualify for a loan, not that they were unwilling to pay market prices.
Thus, for housing demand to be slowed, the total flow of mortgage credit has to be constraining. Sorry for that odd turn of phrase, but stating this is a little tricky because the flow of mortgages doesn’t have to decline or even slow. It simply has to increase (or decrease) at a rate that is less than the counterfactual increase in total home sales minus total home equity infusion.
In any case, the point is that banks have to stop giving people loans.
Loan supply is determined by many things, but two major factors are the collateral value of homes and the income prospects of borrowers. As housing prices rise, the collateral value of homes increases. As new home construction increases, the demand for unskilled labor increases. Both of these factors will tend to increase loan supply.
In addition, mortgage equity withdrawal tends to increase as housing prices increase. This increases consumption and with it, total demand in the economy. This increases the incomes of potential borrowers.
So, increasing housing prices can have a positive impact on loan supply. Indeed, right now, that is likely to be the case.
Total housing demand is not price rationed in the way most goods are. However, the demand for any particular house is. Usually, it goes to the highest bidder. This means the straightforward supply and demand analysis applies on a house-by-house basis.
The upshot is that increases in housing demand do drive up the price of individual home sales. This may seem perfectly natural and obvious, but once we have opened up the implicit system of diff. eq. underlying the housing market, we have to close it back, and this condition closes it.
Housing inventory is likely to keep falling until housing prices rise so sharply that buyers can’t pull together the credit to get a new loan. However, you need a really big price spike to make that happen since, initially, rising prices make banks more willing to lend.
Thus, we should expect roaring housing prices ahead. In their wake, we should expect rapidly increasing new home starts and a boost to consumption from higher home equity.
There also exists the potential for a true liquidity bubble to re-emerge. That would mean even higher housing prices. What we would expect is that the ease of selling a home makes buyers less wary of forking over a big down payment. It also makes it easier for banks to sell non-conforming loans on the secondary market.
These two increases in liquidity mean that folks are willing to pay ever greater prices. In theory, if houses could be sold instantly, then housing prices would have to rise until the rent yield on houses was equal to the dividend yield on stocks or some other financial asset with similar portfolio properties. That would mean really high housing prices, but is extremely unlikely to occur.
In any case, the dynamics we have been talking about for several years now are still in the works. The process was initially slower than I expected. Homebuilders responded with a larger lag than I expected. Inventory has soaked up more excess demand than I expected.
Yet the dynamics continue, and as those sinks fill up, the spillover into prices and new home construction should continue to boom.
This is where I – as should be obligatory – explain why the Sumner Critique doesn’t render everything I just said invalid.
The short answer is that the Fed does not have a strong NGDP target, and the FOMC members are very concerned about the nature of monetary accommodation.
To the extent that a housing boom makes monetary accommodation easier (read: more conventional) the FOMC will buy more of it. Think of the FOMC demand curve for NGDP as being composed of: inflation prints, unemployment prints and news/blog articles on the evils of Quantitative Easing.
Note, I explicitly do not mean the actual values of these variables (should such quantities be well defined), but the official report of these values and/or their appearance in media.