Will the FedÕ inevitable interest rate hike break a fragile recovery?

Capital Economics: Outside dynamics strong enough to meet the challenge

It’s an article of faith that the Federal Reserve will be raising interest rates by the end of the second quarter or sometime in the third quarter of this year, and with the end of the easy-money policy, the question becomes how the housing recovery will be affected by a rise in interest rates.

While some worry that the limping recovery will stall out, other housing analysts say no, it won’t slow things down.

“Affordability is good and housing looks cheap relative to incomes, as well as equities, bonds and commercial real estate,” says Paul Stansfield, chief property economist at Capital Economics

There’s no doubt that the year is off to a bad start for housing in terms of housing starts, completions and permits. Existing home sales tumbled in January, and mortgage applications have been spiraling downward in February, giving away most of the gains made in January.

Privately owned housing starts in February plummeted 17%, down to an annualized 897,000 from the revised January estimate of 1,081,000, with drops in the Northeast, Midwest and West leading the collapse. It was the worst drop since January 2007.

And the latest news is a projection for March: Weak inventory, slowing demand, and rising prices continue to hamper the housing market's recovery, according to the March Real Estate Nowcast.

But Stansfield says it has to be put in perspective.

“Home sales have eased a little over recent months,but are still 5% or so above their level this time last year. Moreover, Realtors have reported a steady increase in buyer traffic in the early stages of the year. Meanwhile, although housing starts slumped in January, the weight of evidence indicates that this was driven by the weather, not a shift in market sentiment,” he says. 

“The fact that credit scores for successful loan applications have started to rise again, however, does suggest that lenders are more nervous,” Stansfield says. “Yet if we are right that the economy will grow by 3.3% this year and 2.8% in 2016, while unemployment falls towards 4.5% and earnings growth accelerates, demand should improve. Our central forecast is for home sales  to rise from 5.36 million in 2014 to 6 million in 2017.”  

Stansfield says that as the year progresses, steady increases in employment and incomes, as well as further falls in the number of households with low or negative equity, all argue that supply should improve.

“And with house price expectations showing no signs of picking up, we expect the pace of house price gains to slow. Our forecasts of 2016 and 2017, that prices will rise by 4%, are unchanged,” he says. “That said, if the Fed delays raising interest rates for too long, house price gains could be 8% or more both this year and next. On the other hand, if credit conditions stay tight, or if we have over-estimated the strength of the labor market, price gains could be just 2% to 3%.”

He says that affordability for homeowners will be good, but the outlook for renters is more challenging.

This reflects the fact that the rental vacancy rate has slumped to levels last seen in the mid-1980s.

“The key point however, is that housing has already made considerable progress towards returning to more normal conditions. That process has further to run, but it should be complete by the end of the forecast horizon,” Stansfield says. 

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