Could the Housing Market, a Bright Spot in the Economy, Overheat?

Family in driveway in front of home.
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Now that the housing market has undeniably recovered from the pandemic, some economists are already talking about the possibility that it may overheat, sending prices to unsustainable levels.

“There are some looming headwinds on the horizon,” said Matthew Speakman, an economist at Zillow, the online housing marketplace, in an email. Demand for homes is outstripping supply, which could result in price increases that “even the enhanced buying power brought upon by low rates can’t keep up with.”

Key Takeaways

  • The housing market has more than fully recovered from the pandemic, with August sales of existing homes reaching the highest monthly level since 2006
  • Just months after the pandemic crash, some economists are already warning of the dangers the housing market could overheat
  • Heavy demand and low supply could end up driving prices to unsustainable levels
  • Other economic realities could provide a cooling effect

Home sales have roared back from a pandemic slump, driven by ultra-low mortgage rates and increased interest from people who now work from home. The greater demand, coupled with a shortage of homes for sale, has invariably led to higher prices. 

The median price for a single-family home in the U.S. crossed the $300,000 threshold for the first time in July and then climbed again in August, reaching $310,600, according to the National Association of Realtors (NAR). And a benchmark index, the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, rose 4.8% in the 12 months through July, accelerating from the 4.3% increase seen in June, the latest reading showed Tuesday.

Mortgage rates, which are indirectly influenced by the Federal Reserve’s benchmark fed funds rate, are expected to stay low after the Fed committed this month to keeping its target for the fed funds rate at virtually zero until inflation has reached 2% and “is on track to moderately exceed 2% for some time,” as Federal Reserve Chairman Jerome Powell put it.

The average fixed rate on a 30-year mortgage fell as low as a record 2.86% in September, down from 3.72% at the start of the year.

The Fed’s “low rates have helped the housing market to pick up strongly, which makes me wonder how much further housing could go if we get a vaccine but rates remain low in an attempt to get inflation above 2%,” David Sloan, senior economist for North America at Continuum Economics, said in an email, referring to hopes for a vaccine against COVID-19. “The biggest risk (if not an immediate one) I see is that we could end up with continually low rates with not much consumer price inflation, but a boom in house prices that may be followed by a bust.”

Indeed, prices may become less affordable as the inventory of homes for sale shrinks. Based on the pace of sales in August, the inventory of single-family homes on the market will only last 2.8 months, according to NAR, which has never recorded as small a supply in the 38 years it’s been tracking it. A 6-month supply of homes for sale is historically associated with “moderate” price increases, while fewer months tends to mean faster increases, according to NAR.

The imbalance between supply and demand “will inevitably harm affordability and hinder ownership opportunities,” NAR Chief Economist Lawrence Yun said in a statement last week. “To assure broader gains in homeownership, more new homes need to be constructed.”

To be sure, while Fed policy should work to keep mortgage rates low, growth in home sales is already slowing. In August, sales of existing single-family homes rose 2.4% from July to an annualized 6 million—the highest level since December 2006—after jumping a record 25% from June to July and 20% from May to June.

Depending on how long it takes the labor market to recover, demand may wane, keeping the market from overheating, according to Kevin Harris, an independent economist. 

“The recent rapid pace of sales is partly just catching up on sales missed due to the pandemic in March and April. Home sales are likely to cool off a bit in the coming months after the scramble to catch up is over,” Harris said in an email. “The big question for home sales on a continuing basis is what happens to employment.”

The pace of job recovery will depend on the course of the pandemic and on the government’s response, Harris said. “The best guess for now is that return to normal in the economy won’t come till 2023,” he wrote. “That is when employment will start making a substantial contribution to housing demand.” 

Zillow's Speakman also views the labor market and potential relief measures as key variables to consider in gauging the future housing market. 

For now, though, “low mortgage rates appear poised to stick around for awhile, meaning that homebuyer demand should persist and the housing market should continue to act as one of the true bright spots of the economy,” he said.