Perhaps as the most telegraphed interest rate cut of recent decades, the Federal Reserve reduced the key, short-term federal funds rate by 25 basis points to a top rate of 2.25%. This policy change is good for housing and home building, which continue to face housing affordability headwinds in spite of favorable demographics.
There were two dissents to the announcement, suggesting a healthy amount of debate among the members of the Federal Open Market Committee. Current macroeconomic issues include trade concerns, slowing global economic growth, the tight U.S. labor market, and an undershoot for inflation. As an additional policy change, the Fed announced it will end its balance sheet runoff program (quantitative tightening) in August. That policy has been in place since October 2017. Together, both moves continue the Fed’s pivot to a more dovish monetary policy stance.
With respect to the overall economy, the Fed characterized the labor market as “strong,” with economic activity rising at a “moderate” rate. This mirrors the home building economic perspective of a slowing overall economy, ongoing labor shortages, and late cycle concerns over housing affordability. The Fed noted that “business fixed investment has been soft,” although the housing market has actually been a more apparent example of that trend in recent quarters, which the Fed would be good to note explicitly.
Inflation was described by the Fed as “running below 2 percent” (its symmetric target), suggesting the central bank has policy room to maneuver to reduce rates if the economy continues to slow. That said, the dissenting views illustrate that additional rate cuts in the near-term are not guaranteed. Indeed, some investors are being too aggressive with an expectation of 75 basis points of rate reduction over the next few quarters.
The NAHB forecast includes an additional 25 basis point cut in the Fed funds rate late in 2019 given muted inflation and slowing growth. The late cycle housing market soft patch that began during the second half of 2018 provides clear evidence of ongoing macro risks, with residential fixed investment down for the last six quarters.
The evolution of Federal Reserve policy over the last three quarters is an important reason why mortgage interest rates have declined from late-2018 cycle highs. Given that the housing market faced a 10-year low for housing affordability last Fall, the Fed’s approach is a net positive for future housing demand and home construction, while offering an offset (but only a partial one) for rising construction costs. These costs are limiting housing inventory, particularly at the entry-level market. Moreover, higher production costs have caused housing affordability to decline in recent years and are the primary driver for NAHB’s estimate for generally flat conditions for new home sales and starts in 2019.