The remarkable resilience of the housing sector amid the Federal Reserve’s historic monetary tightening cycle has been a key factor underpinning the economy’s resistance to recession. A large and volatile sector of the economy, housing is typically a key transmission channel for monetary policy to affect real economic activity. When interest rates go up, homes get less affordable, people buy fewer or smaller homes, and homebuilding slows to a crawl.

With about 8 million construction workers and representing 4 percent of GDP, the sector is big enough that downturns within it, combined with spillover effects on related activity, can induce genuine recessions. And because of its sensitivity to interest rates, housing usually leads the business cycle, providing clear clues as to where the economy is heading.

Yet despite a 25 percent drop in “housing starts,” or new housing units, since last year, construction hasn’t seen widespread layoffs. Why?

First, builders were understaffed before the pandemic, so they never really became overstaffed when starts began to drop off. Second, due to supply-chain problems in 2022, the length of time to complete a housing unit increased—meaning that despite the reduction in starts, more workers were needed than normal, as units under construction remained high. Third, because of interactions of inflation with the tax code, the after-tax real mortgage rate has increased by less than the nominal rate.

Indeed, because of all the pro-cyclical stimulus irresponsibly pumped into the economy by Congress and the Biden administration, nonresidential investment has recently picked up aggressively. Outlays from the infrastructure Investment and Jobs Act, the CHIPS Act, and the highly inflationary Inflation Reduction Act have created a boom in nonresidential structures.

Combined, all these factors indicate that, if a recession is coming, construction will not be its epicenter or its proximate cause. That stands in contrast with several previous cycles.

Moreover, even the decline in housing starts appears to have partially reversed. In the latest data, starts surged almost 20 percent, to levels closer to the boom in 2021 (though this jump may later be revised downward). Homebuilder stocks, meantime, sit within spitting distance of their all-time highs, despite the fastest monetary-tightening cycle on record and precipitous declines in housing affordability.

How to reconcile these forces? Without the initial decline in construction employment (which, in a normal cycle, would have occurred around the end of last year), the recession has been delayed. While the economy continues to expand, some demand for homes remains—people still have kids, get married, change jobs, retire, and move around the area or country.

But with 62 percent of current mortgages locked in at interest rates below 4 percent—and almost one-quarter at rates below 3 percent—few households want to move unless they absolutely must. Refinancing that mortgage will lift interest payments to nearly 7 percent. This “rate lock” discourages households from moving and has kept existing home inventory on the market at very low levels. In other words, because the economy has avoided a major employment downturn so far, the supply of homes has lessened in line with demand for homes, keeping prices relatively stable.

With existing home inventory restrained, homebuilders have supplied a greater share of transactions, since they’re able to bring inventory online while households with older mortgages are stuck in place if they want to keep their low rates. Between 2021 and this April, existing single-family home sales fell by 29 percent, while new home sales declined by only 11 percent.

The key to the puzzle is the lack of existing inventory due to rate lock. Housing is likely to remain strong as long as those homes remain off the market, constraining supply. What, then, could induce a substantial increase in existing home inventory, sufficient to move the housing market?

The likeliest answer runs through changing business realities. As my colleague Allison Schrager has argued, remote work can reduce productivity for firms because employees have less in-person facetime, and it can make it more difficult for younger workers to gain mentorship and skills and impress their supervisors so that they can get promotions. Very likely, many workers would prefer remote work most of the week, while many firms would prefer much less, or even none. Given the tightness of the labor market, workers have had more bargaining power, and many firms have been flexible with remote work, particularly in the suburbs around major cities. With interest rates now north of 5 percent, layoffs will begin picking up pace in non-housing sectors slower to respond to interest rates than housing; but they will eventually respond.

As the labor market begins to loosen, bargaining power should shift from workers to employers. Once a firm decides to downsize its workforce, it becomes easier to limit the number of remote workdays, potentially to zero—and if a worker doesn’t like that, he volunteers to be in the portion of the workforce being laid off. Indeed, signs suggest this process is underway in the tech and financial sectors, two industries that are cutting headcount.

If remote work recedes, more families will move. The big house two hours outside of the city makes a lot of sense for a worker commuting one day a week, but less sense for a worker commuting every day. Many households who bought bigger homes farther from downtowns will choose to reverse their decisions.

Reshuffling due to reduced remote work would unlock the elusive inventory of existing homes. Households forced to move by changing commute requirements can lift market volume and inventory, potentially facilitating a correction in home prices. This is particularly true in suburban towns, where prices rose by 20 percent to 40 percent after the pandemic, but where downtown areas have seen steady or smaller increases, or even declines.

In other words, a turn in the jobs market has a good chance of turning the housing market in tandem. We live in a world of multiple equilibria; a particular equilibrium can feel stable until suddenly it’s not. It often takes a large shock to move the world from one equilibrium to another. The Fed’s hiking cycle counts as one of those large forces.

Housing weakening at the same time as the jobs market would naturally accelerate any downturn. The housing market’s defiance of interest rates thus far has disrupted the normal sequence of leading and lagging indicators, meaning that housing may, counterintuitively, be a lagging indicator in this cycle, to the surprise of most economists. This also means that when a recession eventually comes, it is likely to come fast and hard.

Photo: Andrii Yalanskyi/iStock


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