The Impact of Inflation on Housing Prices

By Brent Bowen

November 01, 2022

The topic of inflation has dominated the news lately. Let’s put aside the causes of the high rate of inflation and instead take a closer look at what impact it has on housing prices.

Let me preface this by saying I don’t have a crystal ball (or a DeLorean), so I can’t tell you what the future holds. There are multiple factors at play in the supply and demand for housing that often have contradictory effects. Be that as it may, the high rate of inflation does add some new variables to that equation that are worth noting.

First, let’s talk about effective demand. There are a lot of potential buyers out there, but what counts for effective demand is the willing and able buyer. I will discuss this ability in terms of buying power.

The effect of mortgage interest rates as they change

The Fed has been implementing changes in monetary policy to deal with inflation. These actions have correlated with significant changes in interest rates. This graph shows interest rates for 30-year mortgages over the past five years.

The increased rates have had a significant impact on buying power. Consider this scenario:

A buyer with a budget for a mortgage payment of $2,000 per month has saved $100,000 for a down payment. The maximum house price the buyer can afford changes drastically depending on the interest rate environment:

Interest Rate	3%	6.5%
Loan Amount @ $2,000/month	$474,000	$316,000
Down Payment	$100,000	$100,000
Maximum Budgeted House Price	$574,000	$416,000

In this example, the increase in interest rates from 3% to 6.5% results in a $158,000 loss in buying power. This means that a house that was at the top of the buyer’s budget when rates were 3% would have to drop in price by more than 27% for it to be affordable to the same buyer when rates hit 6.5%.

That puts history into a little bit of perspective. Glance back at that interest rate graph and you can see that the drop in interest rates between 2019 and 2021 resulted in exactly the reverse scenario described in the example above. The drop of interest rates from the high 4% range to the high 2% range accounts for a significant portion of the historic growth in home prices during those two years.

Consumer prices also come into play

The interest-rate effect isn’t the only factor related to inflation that impacts effective demand. Consider the rest of the budget for our example buyer. According to June 2022 data from the Bureau of Labor Statistics, wages and salaries had increased 5.3% compared to the prior year. Good news! A little more money in the pocket for buyers—but what about their expenses? As of June 2022, the inflation rate (Consumer Price Index) was reported at over 9%. Thus, while buyers may have more income, they likely lost a lot of ground when it comes to expenses. This increase in expenses means that the buyer in the example is going to have a harder time making that monthly payment. It is not unreasonable to deduce that some of the money budgeted for a house payment will end up getting spent on groceries, gas, and other items. This has a direct impact on buying power.

You might wonder if we are headed for a housing market crash. Don’t jump to conclusions too quickly.

Mitigating factors

There are other forces at play when it comes to inflation. Remember, effective demand involves a willing and able buyer. High inflation creates an incentive not to hold cash. In an inflationary cycle, holding cash is a losing game. Every day, that same dollar will be able to buy less. There is therefore an incentive to transfer cash into hard assets like real estate. There are also demographic changes in our population that continue to impact the overall demand for real estate. The most significant demographic change is the population bulge of millennials at the prime homebuying age.

Lest we forget, demand is only half of the equation. The supply of housing has increased relative to demand but remains low in many markets. Consider a market where there were 10 buyers for every seller. Inventory could double and demand decrease by half, and you would still have a seller’s market.

Buyer and seller expectations matter, too

In the short run, expectations—what buyers and sellers think will happen in the future—can have a huge impact on the market. In several areas where I work, the initial increase in interest rates actually caused prices to increase for a brief period of time. Buyers who could afford the initial increase in rates—and who also anticipated rising rates to continue—feared being priced out of the market in the long run, so they chose to pay premiums to lock in their rate and price now. This phenomenon was short-lived but demonstrates the power of perception in driving pricing decisions, even when those decisions may be counter to the actual changes in market conditions.

Looking ahead

While nobody knows what the future holds, cycles of high inflation have happened before. For those of us who weren’t born yet (or weren’t old enough to be watching the news in the 1970s when inflation hit double digits), it might be worth your time to do a little research. I recently stumbled upon Money Mischief: Episodes in Monetary History by Milton Friedman. The book has some excellent analysis of inflation. Inflation will eventually impact the national debt, tax rates, government spending, and the output of the economy as a whole (GDP). Becoming more informed and remaining aware in this ever-changing world will help us better serve our real estate clients and prepare our businesses to navigate changing market conditions.

A version of this article was previously published in Appraisal Buzz.

Brent Bowen is a Texas Certified Residential Appraiser and President of Texas Valuation Professionals, Inc. in Plano. After graduating from Baylor University with an enthusiasm for both economics and real estate, appraisal became a perfect fit and has continued to be his focus for the past 25 years.

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There are multiple factors at play—often with contradictory effects—in the supply and demand for housing. Learn what happens when you add inflation and higher interest rates to the mix.