The rise in mortgage interest rates in March-April 1996 was followed by predictions that housing sales and the volume of residential construction would contract. Through June, however, sales of existing and newly built homes and starts of new homes held at the highest rates in two years. This is longer than can be explained by a rush to buy before mortgage rates rose even higher. The relationship between interest rates and housing activity is not as powerful as assumed.
Back when the Federal Reserve's Regulation Q put a ceiling on the interest rates banks and thrifts could pay for more deposits, housing activity declined swiftly once interest rates rose above those ceilings. Depositors turned away from the banks and thrifts to seek higher yields by investing directly in money markets. Deprived of new deposits and faced with withdrawals, housing lenders were forced to turn down new mortgage applications. Sales of existing homes slowed and new construction nose-dived.
Reg Q was phased out in the 1980s, and with it has gone a predictable response in the housing market to increases in rates. The chart indicates the correlation of rising rates and falling housing starts has not been close over the last 15 years with the exception of 19811984, when interest rates first soared and then dropped sharply and Regulation Q was still partially in effect.
That housing activity does not move in lockstep with every change in mortgage interest rates is not surprising given that the monthly mortgage payment is only one determinant of a household's ability to buy a house. Trends in household income and wealth and changes in attitudes play major roles as well. In this regard, it is not surprising to find the steepest declines in housing starts during the period covered by the chart coincided with recessions, the first in 1981-82 and the second in 1990-1991. Slower growth in real incomes and rising unemployment discouraged home buyers.
Another factor that blunts the impact of higher rates is the greater choice homebuyers have in the mortgages they select than was available during the days of Reg Q. When rates on conventional, fixed-rate mortgages rise, homebuyers display a preference for adjustable-rate mortgages with their lower rates.
There are a number of reasons to expect housing sales and starts to be resilient in the face of the recent rise in rates. As the chart illustrates, the rise of more than one percentage point in the interest rate on 30-year conventional mortgages since February is moderate compared to the steep rise of the early 1980s or the 1994 increase. …