An Era Ends
Last month I wrote about the Administration’s budget proposals that could negatively impact residential real estate values in richer states and regions. To recap, the President and some members of Congress are trying to eliminate the Federal income tax deduction for state, property, and, local taxes, usually referred to as SALT. They see terminating or reducing this tax preference as a significant revenue source. If passed, San Diegans will have fewer after-tax dollars to spend on goods and services. In the 53rd Congressional District, for example, taxpayers using this deduction saved 109 million dollars in Federal income taxes in 2015; a substantial part of these dollars subsidized housing prices.
This column will look a second worrisome external factor, the inevitable changes coming next year to the Federal Reserve Board’s monetary policies. Since The Great Recession began, the Federal Reserve Board has kept mortgage rates exceptionally low. The Fed accomplished this by purchasing existing debt, mainly U.S. Treasuries and agency and non-agency bonds. In other words, they injected cash into the banking system and reduced the supply of debt available on the marketplace. Known as Quantitative Easing (QE), the Fed bid up the price of bonds and bond-backed securities, which drove interest rates in the opposite direction. At the inception of QE, housing prices nationwide were in a free-fall, destroying and weakening the nation’s financial institutions. The Fed feared a possible deflationary cycle; it aggressively kept short and long-term interest rates as close to zero as possible by flooding financial markets with cash. By keeping home loan rates at historic low levels, the Board’s actions stabilized home prices, protected the economy and the banking system from a ruinous Depression-style deflationary cycle.
Eventually the Fed shows up at the cheap-money party and takes away the punch bowl. They have good reasons to do this. First, the Fed is holding four trillion dollars worth of debt they purchased during QE. Economists have no clear consensus on how to dispose of these assets or even whether or not it is important to completely unwind QE. Second, the Board believes the nation’s economic health is such that interest rates can be allowed to slowly increase. By selling off small bits each month from their vast trove of bonds, the Fed is carefully increasing the supply debt instruments on the marketplace. Increasing yields and higher mortgage rates will surely follow as there will be downward pressure on bond prices. Fewer buyers will be able to afford homes and those who can will pay more for the privilege.
This shift in direction may seem counterintuitive given the fact inflation remains stubbornly under the Fed’s target of two percent and GDP growth, while improving, remains lackluster. Deflation was the economic devil to be tamed over the past few years; the FRB must believe that danger is past.
Complicating matters, Janet Yellen’s term as Chair is over in March. There are also two open seats on the Board. The President, as seems to be his wont, has issued a series conflicting signals on who will be her successor. He has both criticized and praised her and recently the White House signalled that Ms. Yellen could be renominated, although that is probably not likely since she was appointed by his predecessor. (in any case, she remains for another term as a Governor if she chooses to do so). The current front runner for her post is known as “Yellen 2.0”, and that is good news for housing in particular and the economy in general.
The nomination for the Chair, as well as the other open Board seats, are relevant to San Diego real estate. The political composition of the Board next year is still not clear. The White House apparently does not have a clear position, nor has articulated one, on how it wants the FRB to run the economy. Whether or not the Board is dominated by deficit hawks or accommodators, they may not take kindly to the GOP’s newly discovered love affair with deficit spending. Finding the Goldilocks solution is always difficult and I sincerely hope the White House sees fit to staff the 2018 Board with Governors who will follow Ms. Yellen’s example. Until the team is set, it will be hard to predict just how high mortgage rates will go in 2018.
There is one inescapable conclusion. A cocktail of reduced or eliminated real estate tax preferences and higher mortgage costs should affect aggregate effective demand for homes in 2018. Next year buyers will not be able to afford what they could buy in 2017. Whether this translates into lower or flat pricing depends largely on what happens in the Beltway over the next few months.