The economy is doing well, except for one huge problem

Amid the recent flood of data showing the economy is progressing smoothly, one sector remains consistently out of whack, and it’s a big one: homebuilding.

On Thursday, a report from the Bureau of Economic Analysis showed that rising home costs helped core inflation exceed the Federal Reserve’s annual target of 2%. A decline in housing construction in the third quarter slowed the overall pace of economic growth, according to a Bureau of Gross Domestic Product report released Wednesday. Earlier this month, data showed that home construction had slowed and sales of existing homes fell to their lowest level in more than a decade in September.

The beleaguered housing market stands in stark contrast to other important pillars of the economy, which are running relatively smoothly: The job market continues to grow, consumers spend freely and inflation is falling.

At the heart of the problem is the fact that high prices and high mortgage rates have made the cost of buying a home unaffordable for people with typical incomes who could previously afford the payments. The mortgage payment for a typical newly purchased home will be 42% of median household income in August, up from 29% in January 2020, according to the Atlanta Federal Reserve Bank’s Housing Affordability Monitor.

Housing problems hurt the overall economy, hurt family budgets, and prevent people from moving to take advantage of job opportunities, among other ripple effects.

High mortgage rates hurt budgets

The housing market has become collateral damage in the Federal Reserve’s war on inflation.

“When the Fed raises interest rates, it hits the housing sector the hardest because it is the most rate-sensitive sector,” Bill Adams, chief economist at Comerica Bank, told Investopedia.

Mortgage rates hit record lows during the pandemic as the Fed kept its powerful benchmark interest rate near zero to stimulate the economy. But when the Fed raised rates sharply in 2022 to fight inflation, mortgage rates rose. By October 2023, the average rate offered on a 30-year mortgage reached a two-decade high of 7.79%, up from a record low of 2.65% in January 2021, according to Freddie Mac.

The trauma has all but paralyzed the housing market as homeowners, who had secured ultra-low interest rates during the pandemic, were hesitant to sell their homes and trade them in for new mortgages at higher rates.

This “lockdown” effect has left far fewer homes on the market than before the pandemic, according to the National Association of Realtors. And home developers haven’t kept up with demand for new homes, in part because local zoning rules limit new home construction where it’s most needed. Additionally, demand for larger homes has skyrocketed during the pandemic as workers have adjusted to the new work-from-home lifestyle.

“Since the pandemic, there has been a huge jump in the amount of living space Americans want because many more Americans are now working from home or working from home some days,” Adams said. “Demand for residential space in the United States is consistently higher than it was before the pandemic. This is the downside of all these empty offices in the center of big cities.”

All these forces combine to keep prices at record highs, even as many buyers have been priced out of the market.

What’s next?

One part of this equation—mortgage rates—could improve in the near future.

The Federal Reserve cut the federal funds rate from a two-decade high in September and plans further rate cuts in the coming months as inflation falls to its target of 2% annually. Although mortgage rates do not always move with the federal funds rate, they are influenced by it. Fannie Mae forecasters expect mortgage rates to fall to the mid-5% by the end of next year, down from 6.72% last week.

“2024 was a really tough year for the housing market,” Adams said. “2025 should be a better year because the Fed is cutting rates.”

However, this forecast could change depending on which party wins Tuesday’s general election. Both presidential candidates touted plans to ease the housing shortage, with Vice President Kamala Harris promising to build 3 million affordable homes and former President Donald Trump promising to free up homes by deporting immigrants.