Two house price inflations, two central banks

Published in Housing Finance International.

In 2021, North America is the home of runaway house price inflation. In both the U.S. and Canada, house prices are far over their Bubble peaks of the first decade of the 2000s and they continue to rise rapidly. In both countries, they are increasing at double-digit annual rates: over 15% in the U.S., according to the AEI Housing Center’s current estimate, and 11.9% in Canada, according to Teranet. They are journalistically described by terms like “surging,” “soaring,” and “red-hot.”

The Case-Shiller national index of U.S. house prices is at about 243, compared to its 2006 Bubble peak of 184. That puts it 32% higher than at the top of the Bubble. “Record-high home prices are happening across nearly all markets, big and small,” says the National Association of Realtors.

In Canada, the comparison is even more striking. The Teranet Canadian composite house price index is at about 261, almost double its 2008 peak of 133.

Anecdotes match the numbers. “Brokers describe the current market as frenzied,” the Wall Street Journal reported. “Many homes receive multiple offers within days.” One Texas broker “said she has never seen a market like this before. In some cases, buyers are offering $100,000 above asking prices. …It’s just crazy, there’s no other word to describe it.”

One Canadian commentator wrote recently, “A sellers’ market prevails…I was surprised to learn that bidding wars…were now common in my hometown, Windsor, Ontario, for sales of even relatively modest houses.” Windsor is a modest industrial city, across the river from Detroit, Michigan.

This house price inflation of both countries, far outrunning the growth of wages, is obviously not sustainable, but it has already gone on longer and to higher prices than many thought possible, including me. As one of my economist friends said recently, “It can’t go on, but it does.”

Very appropriately, in my view, the Bank of Canada in February discussed “excess exuberance” in Canada’s housing market. In April, it added that this market shows “signs of extrapolative expectations and speculative behavior” – strong language for a central bank to use. The term “excess exuberance” is obviously a variation on the “irrational exuberance” made famous by then-Federal Reserve Chairman Alan Greenspan in 1996, warning about the dot.com stock bubble of the day. That bubble pushed prices up for three more years after Greenspan’s warning, but did ultimately implode. How long will the Canadian and U.S. house price inflations continue, and how will they end?

The Federal Reserve is far less direct than the pointed comments of the Bank of Canada, but it also discusses house prices, albeit with much blander language (or “Fedspeak,” as we say in the U.S.). In its updated Financial Stability Report of May 2021, the Fed observes about asset prices in general, “Prices of risky assets have risen further” and “Looking ahead, asset prices may be vulnerable to significant declines.” True, and it applies among other things to house prices. A number of my financial friends were particularly amused that this report never mentions the Fed’s own continuing role in stoking the inflation of asset prices and the systemic risk they represent.

Specifically on housing, the Fed says, “House price growth continued to increase, and valuations appear high.” Further, “Low levels of interest rates have likely supported robust housing demand.” Yes, except that we need to change that “likely” to “without question.” Implied in this statement, although not made explicit, is how vulnerable house prices, which depend on financing with high leverage, are to interest rates rising from their current historic lows of 3% or so.

What might a more normal interest rate be for the typical U.S. 30-year, fixed rate, freely prepayable mortgage? We can guess that if inflation were at 2%, and the 10-year Treasury yield at inflation plus 1.5%, and the mortgage rate at 1.5% over the 10-year Treasury, that suggests a mortgage rate in the 5% range. An increase in U.S. mortgage interest rates to this level would doubtless entail major house price reductions. (Of course, general inflation going forward may be higher, perhaps a lot higher, than 2%.)

The single most remarkable factor in the U.S. housing finance system at this point is that the central bank has become a massive investor in long-term mortgages. This started as a radical, emergency action in 2008 and ballooned again as an emergency action in 2020, but continues to expand – for how long? As of May 26, 2021, the Fed owned over $2.2 trillion in mortgages at face value, or over 20% of the whole national market. It also reported $349 billion of total unamortized premiums on its books. Assuming half of that is for mortgages, the Fed’s total investment in mortgages is $2.4 trillion. It is by far the biggest savings and loan in the world and getting constantly bigger.

In instructive contrast, the Bank of Canada stopped buying mortgages last year, in October 2020. But the Fed keeps buying, continuing to increase its mortgage portfolio at the rate of $40 billion a month, or $480 billion a year. The central bank thus continues to stimulate and subsidize a market already experiencing a buying frenzy and runaway price inflation – a fascinating, and some would say, astonishing, dynamic in unorthodox housing finance and central banking. The Federal Reserve, like the Bank of Canada, should stop buying mortgages.