New Fed Paper Argues Surging Home Prices are Driven by Demand, Not Supply

July 7, 2022

Price increases are driven by an imbalance between supply and demand, but understanding whether the problem is insufficient supply or excess demand is important, particularly for the Federal Reserve and its efforts to combat inflation. After all, excess demand can be tamped down by raising interest rates, but higher rates can do little to increase the supply of oil, wheat, or houses.

It is houses in particular that a recent working paper from the Fed focused on. Home prices have seen historic increases in the years since the pandemic began, sparking concerns about affordability and potentially even the creation of another bubble in the housing market.

To better understand what drives short-term fluctuations in home prices, economists at the Fed examined two decades’ worth of property listings from 2002-2021 and created a model that captures the inventory of homes coming onto the market and the influx of prospective buyers.

Their findings show that demand is largely responsible for driving up prices. 

“Fluctuations in housing demand explain much more of the variation in home sales and price growth than do fluctuations in housing supply,” the researchers argue. They conclude that “fluctuations in demand explain essentially all of the variation in home sales, and 80% of the variation in prices, between 2002-2021.”

The paper uses the housing market in the months after the pandemic began to highlight this dynamic. Home listings fell at the start of the pandemic as uncertainty weighed on buyers and sellers. Within months, the authors argue, strong demand overtook tight supply as the primary factory driving the market, and offsetting this demand would have required new home construction to jump by 300%.

This explains only short-term fluctuations of course, and over the long-term increasing construction to maintain a balance between supply and demand makes more sense. However, the research does help explain why the Fed has opted to stabilize home prices by raising rates. The researchers estimate that a 1% increase in the mortgage rate lowers housing demand by 10.4%.

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