In 2023, the housing market seemed poised for a correction due to sky-high property prices, the highest mortgage rates in decades, and economic uncertainty. However, that hasn’t happened. The property market has remained flat for most of the year, and some reports suggest that it is even rising.
Is this possible? How have residential housing prices managed to remain so resilient despite all the headwinds?
How the Economics Work
To understand, let’s look at the economics. A market economy’s prices are determined by supply and demand. Here’s a quick refresher course if you’ve never taken an economics course or haven’t taken one in a while.
Supply refers to the amount of goods available for sale. Housing market supply inventory is referred to as supply. A product’s demand is how many people want to buy it. Typically, this is investors and homebuyers. In economics, equilibrium occurs when supply and demand meet on a spectrum (called a curve).
In terms of price and quantity, equilibrium is what the market can support. A point in time when supply and demand are in balance.
In July 2022, based on supply and demand, 527,000 houses were sold at an average price of $415,000. This is the number of sales and the average sale price the market could support, given the many factors affecting supply and demand.
However, supply and demand are not static. According to the price and quantity of transactions in the market, the curves shift and change over time. As a result, there will be more sales (quantity) at a lower price if supply increases (more stuff to buy).
The Current Situation
There has been a significant change in supply and demand since last summer. In response to high inflation, the Federal Reserve has raised the federal funds rate, causing mortgage rates to spike. The result has been a decrease in demand, as predicted.
Supply and demand tell us that when things get more expensive, demand decreases. According to the Mortgage Bankers Association’s Purchase Index, demand for purchase mortgages (as opposed to refinances) has plummeted even further than during the financial crisis.
Increasing interest rates caused home prices to decline in 2023, which was why so many forecasters predicted this.
The equilibrium shifts downward when demand drops and supply remains constant. Both quantity (number of home sales) and average price (per transaction) decline.
The idea that prices will decline is based on the assumption that supply (also known as inventory) will remain constant. That’s not what happened. As a result of the lock-in effect, inventory has fallen from 2022 levels.
In July 2022, inventory was around 1.24 million. In July 2023, inventory was about 980,000.
In a situation where supply and demand both drop proportionally, what happens? Quantity (sales volume) decreases while prices remain relatively flat. Although equilibrium shifts, it declines only in terms of quantity, not in terms of price.
We’re seeing exactly this. Despite a drop in sales volume of 15%, home prices have remained relatively flat throughout summer 2023.
It is impossible to predict what will happen in the future. There is always a change in supply and demand. However, if you want to understand what has happened so far in 2023 and why the market hasn’t fallen, look no further. Prices have driven demand out of the market, but supply has decreased somewhat proportionately, resulting in lower sales volume but constant prices.
What Should We Expect For 2024?
Looking ahead to 2024, what will drive supply and demand? What impact will the many uncertain market forces have on equilibrium?
The supply of goods is not likely to move much. There is a lock-in effect, and foreclosures are still below historical averages. While new construction is solid, due to build times, it won’t make a dent in inventory anytime soon. Until mortgage rates reach 6%, we won’t see a meaningful increase in new listings.
Demand is less certain. As long as interest rates remain at current levels (7.5% and even go up), we can expect demand to deteriorate. Unemployment and a major break in the labor market could also lower demand. It is likely that prices will come down a bit (but not much because supply is stable).
It is almost certain that prices will increase in 2024 if mortgage rates decline and the economic picture gets less cloudy.
How will these scenarios unfold? It’s hard to tell. We will have to wait to see how inflation and labor market data, as well as Fed policy, change.