The Fed's interest rate cuts could have unintended consequences for the real estate market

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CNN
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In recent years, the U.S. economy has squeezed inflation out of virtually every sector like dirty water—except for the housing market, which remains paralyzed by high prices and chronically low supply.

But the policies that could help solve America's housing crisis could potentially make it worse. To understand why, let's take a look at how it got here.

At the heart of the housing puzzle lies an imbalance between supply and demand. It's economics 101: There are more people ready to buy than there are homes for sale. That was true even before the pandemic hit and drove demand up. The market had become nearly inaccessible after mortgage rates fell from historic lows in 2020 to their highest levels in a generation last year.

When the Federal Reserve (almost certainly) begins cutting interest rates on Wednesday, it should theoretically cause turmoil in the markets.

Much, however, depends on how vigorously the central bank moves to reduce borrowing costs across the board.

A half-percentage point rate cut – which seems unlikely but not impossible – would signal to the market that the Fed is serious about reversing the “lock-in effect” that causes homeowners with low-interest mortgages to be unwilling to sell their properties in a high-interest environment.

If the Fed changes course as aggressively as it has with interest rate hikes, financing costs would fall, leading to a flood of existing home supply and easing price pressures somewhat.

“As counterintuitive as it sounds, in this post-pandemic cycle, this would be an absolute plus,” Daniel Alpert, managing partner at Westwood Capital, tells me. Lowering home ownership costs also pulls people out of the rental market, and that in turn lowers rents – what Alpert calls a “Goldilocks scenario.”

But a slower, gradual easing is unlikely to really encourage homeowners to move, especially those who secured mortgages at less than 3 percent at the start of the pandemic, especially given that American home prices remain at record highs.

That is part of the supply problem.

While the Fed can't build houses, it can – by indirectly influencing mortgage rates through its benchmark interest rate – make the prospect of selling more attractive for homeowners. Expectations of a rate cut at the Fed's September meeting have already pushed mortgage rates down to 6.2 percent last week, from 6.7 percent in early August.

“If the Fed takes a more dovish stance, I think we could go down to about 6%,” Daryl Fairweather, chief economist at Redfin, tells me. “And I think if we even go down to 5.9%, that would really have a psychological impact on the housing market. I don't think it will take us all the way back to pre-pandemic inventory levels. But it could make a lot of people decide.”

Potential homebuyers, meanwhile — and people who have bought a home in recent years — are clamoring for any relief they can get. The current average mortgage rate of 6.2% is, of course, preferable to last year's high of 7.8% — a difference that could translate into several hundred dollars in monthly payments.

All of this brings us to the potential unintended consequences of the Fed's actions this week and in the coming months. By solving the demand side of the equation without solving the supply problem, the Fed could end up exacerbating the home affordability problem it is trying to solve.

As my colleague Samantha Delouya wrote this week, a decline in mortgage rates could be a double-edged sword.

“This is one of those things where you have to be careful what you wish for,” said Greg McBride, chief financial analyst at Bankrate. “A further drop in mortgage rates could trigger a surge in demand that makes it harder to actually buy a home.”