In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain the economic concept of demand elasticity and why housing market demand tends to be inelastic in response to rising mortgage rates.
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“We may expect higher mortgage rates in the months to come as the economy improves, and higher rates alongside double-digit nominal house price growth, like we're seeing now will impact affordability and purchase demand. But, demand will still be strong because purchase demand is a little bit more interest rate inelastic, and certainly much more so then refinance demand.” – Odeta Kushi, deputy chief economist at First American
Odeta: Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American. And here with me is Mark Fleming, chief economist at First American. Hi, Mark, I've got a question for you. If the price of gasoline goes up dramatically tomorrow, would you still buy gas?
Mark: Hey, Odeta. Yeah, I would, because I need my car for everything from going to the grocery store to taking my kids to 7 a.m. Saturday morning soccer games. Oh, sorry, I digress. Why do you ask?
Odeta: Oh, 7 a.m. soccer game on a Saturday. I guess what you're saying is that gasoline is a relatively price inelastic good, because even large changes in the price do not materially impact demand. Whereas other goods think of a food item, like a lemon, for example, is probably more price elastic. If the price of a lemon increased by 50% overnight, I'm less likely to purchase or demand it. And, believe it or not, that brings me to today's housing topic, the interest rate elasticities of housing demand, how much does our demand for housing change when interest rates change? And you know how we'd like to bring in a little bit of history. So, before we get to those elasticities, let's take a look back at what's happened to home sales and house prices during various rising mortgage rate areas.
Mark: Odeta, I'm still stuck on why you chose a lemon for your elastic good example. I might have picked limes.
Odeta: I have a lot in my fridge. A lot my fridge.
Mark: Okay, you're right. We love our walks down memory lane. And when we walk down this memory lane, the important thing to understand is, you know, do mortgage rates always cause the same effect in home sales? And when we look, the answer is no. I mean, sure in 2005 and 2006, rising rates preceding the housing crisis standout because existing home sales fell dramatically, maybe for some other reasons, not necessarily just rising rates. And back in 1994, existing home sales also went down when rates went up, as the Fed was increasing the funds rate and there was strong economic growth feeding inflation. But then there are plenty of examples where they didn't. There were four other eras – 1996 right before the beginning of the millennia, in 2013 existing home sales actually kept going up even though rates went up as well. So, context matters. Each rising rate era is different, and the housing markets response is different depending upon what's going on.
Odeta: That's a great point. And we actually find that house prices are even more resilient to rising rates than sales. So apart from the 1994 rising rate period, when house prices declined slightly and briefly, house prices have always continued to rise, albeit more slowly, when rates have increased. In the 2005-2006 housing bubble, house prices eventually declined after initially increasing, but actually never declined below the level at the beginning of the rising rate era. Now, in the longest rising mortgage rate era in 1998 to 2000, nominal house prices increased consistently with the economic recovery from the previous recession and, in just over a year and a half, house prices increased 14%. House price appreciation is resistant to rising rates primarily because home sellers would rather withdraw from the market than sell their home at a lower price, a phenomenon we've always referred to as downside sticky. So, the history is obviously interesting. But let's get down to the elasticities. We talked about home sales and prices. But, I actually want to focus on the interest rate elasticity of home sales and refinances.
Mark: Elas-what-tity, what's it? What's an elasticity? I think we might need to define that first. And I'm not talking about the stretchiness of rubber bands here. This is an economics a term called demand elasticity, which really refers to how much the quantity demanded would change in response to a specific amount of change in a specific factor that determines demand. And okay, okay, we have to say it, if all else held equal. I can't resist. I'm an economist. In the housing market, we pay particular attention to the amount of change in demand in response to changes in mortgage rates, right? Measuring this elasticity of demand, what do we find? Rising mortgage rates generally, all else held equal, I had to say it, results in fewer home sales, yes, but more importantly, much fewer refinances. There's a big difference. In other words, we find that refi demand is much more sensitive, in other words elastic, to rising rates than purchase demand, which is inelastic.
Odeta: Well, that makes sense, right? Because when you refinance your home, oftentimes, that's a strictly financial decision, are current interest rates lower than my mortgage rate, if so, it may be wise to refinance, so I can lower my monthly payment. For example, the average 30-year, fixed-rate mortgage in May was 2.96%. While the average interest rate on outstanding mortgage debt in the first quarter was 3.5%. So, that implies that there are many borrowers who are in the money to refinance. And that makes refinances much more sensitive to rising rates in theory. And our back of the envelope calculation finds that if mortgage rates increase from 3% to 3.5%, refinance applications would decline by nearly 30%. So that's pretty elastic. Is it the same for purchases? Surely, people are calculating the net-present value of after-tax cash flows being discounted by the home buyer’s required rate of return? Which is dependent on rates? Right?
Mark: Yes, if by people you mean just yourself, then absolutely. Air quoting here, people are doing that? No, of course not. For the financial part of the equation, people are looking at what monthly payment they can afford. It's really that simple. But, for the rest of the decision, it's actually lifestyle, which has nothing to do with finances. So Odeta should we preview our upcoming HPRI to make this point?
Odeta: I think so. Our HPRI, or our Homeownership Progress Index is actually an annual report that provides a deeper look into changes to homeownership rates over time by accounting for and isolating the impact of critical lifestyle, societal and economic trends that influence the likelihood of renting or owning a home. For example, increasing marital rates, household size, educational attainment, income and improving economic conditions all increase potential demand for homeownership. So, the HPRI measures the potential for homeownership demand based on these underlying factors. And what we find in 2020, is that factors such as rising educational attainment and a higher share of married households contributed positively to the growth of potential homeownership demand. That's because again, buying a home is a financial and lifestyle decision. So, with all of that said, how would a 50-basis point increase in mortgage rates impact home sales?
Mark: 50 basis points, you mean half a percent, right?
Mark: Well, going from a 3% mortgage, we're just a little bit above that right now, to say a 3.5% mortgage rate, that's your 50-basis point or half a percent increase, we estimate roughly that it would reduce purchase mortgage applications by about 5%. Now, that is a decline, but a relatively modest one. By comparison though, clearly rising mortgage rates on the refinance side are multiples higher than that. So, it's not as much about refi demand. As we already mentioned, purchase demand is much less
Odeta: So, all of this to say, we may expect higher mortgage rates in the months to come as the economy improves, and higher rates alongside double-digit nominal house price growth, like we're seeing now, will impact affordability and purchase demand. But, demand will still be strong because purchase demand is a little bit more interest rate inelastic, and certainly much more so then refinance demand. Thank you for joining us on this episode of the REconomy podcast, be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at blog.firstam.com/economics. And if you can't wait for the next episode, please follow us on Twitter. It's @odetakushi for me and @mflemmingecon for Mark. Until next time.