BY ANIRBAN BASU Chairman & CEO of the Sage Policy Group in Baltimore, Maryland. Interest Rates and the Recession That Never Materialized Surging interest rates over the past 18 months have made the current economic environment challenging for many stakeholders, including those situated within Maryland’s housing industry. The headwinds generated by these elevated rates not only amplify the hurdles the economy will face in the near term but also jeopardize the Federal Reserve’s attempts to moderate rising prices without inducing a severe downturn. The Fed’s actions in the last year and a half have been aimed at achieving a “soft landing.” However, the actual outcome remains uncertain because the effects of rate hikes are often delayed. Milton Friedman and Anna Schwartz, the godfather and godmother of monetary economics, taught us that monetary policy operates with “long and variable lags.” While not fully committing to a soft landing, Federal Reserve Chairman Jerome Powell has indicated that the current economic indicators seem to lean toward such a scenario. In other words, the recession that many economists and market analysts have been predicting for the past two years might never materialize. This view appears to align with the ongoing Federal Reserve strategy, although the chairman has not confirmed it explicitly. In recent months, interest rates have remained stable but elevated, with Fed officials maintaining their policy stance. These developments suggest that they anticipate a soft landing in the near future. That said, not every Fed official agrees with the current pause in rate hikes. Some members have advocated for more increases, while others favor a wait-and-see approach, pointing to data that shows only a modest rise in consumer prices. Despite these varying viewpoints, the consensus within the Fed is that a soft landing is within reach. Updated projections also paint a positive picture, with no forecasted recession and unemployment not expected to exceed 4.5%over the next three years. Furthermore, real GDP growth is predicted to remain above 1%. However, it’s not all smooth sailing ahead. Historical data suggest that achieving a soft landing is uncommon. Additionally, the present economic vulnerabilities, coupled with global conflicts in eastern Europe, south Asia, and the Middle East, further complicate the situation. The cautious strategy adopted by Fed officials seeks to strike a careful balance between controlling prices and fostering economic stability and growth. The implication is that while the Federal Reserve may be done raising the target range of the federal funds rate, it may be years until they meaningfully lower it. According to the most recent Wall Street Journal Economic Forecasting Survey, the consensus expectation is that the federal funds rate will be lowered by just one percentage point between now and the end of 2024. For housing in Maryland, this means that the market will continue to be defined by high home prices, low inventory levels, and a lack of affordability—especially for would-be first-time homebuyers. Those dynamics have contributed to what has been lackluster economic growth in the Free State since the start of the pandemic. Maryland’s Stagnant Economy Maryland is one of only 12 states that has yet to regain all the jobs lost during the early months of the pandemic, with payroll employment currently 0.4% smaller than in February 2020. While many states that have recovered slowly from the pandemic have seen an acceleration in hiring in recent months, that hasn’t been the case in Maryland. Maryland’s employment base is up just 1.4% over the past year, the 36th slowest rate of growth among all states. The state’s population has also been stagnant in recent years and actually contracted in 2022, down 0.2% from 2021. That performance ranks tenth worst among all states. Despite this disappointing economic performance, Maryland’s unemployment rate currently sits at 1.6%, the lowest among any state. While lower unemployment rates are traditionally viewed as a good outcome, and Maryland is far from the only state dealing with labor scarcity issues, the current rate of unemployment is too low to support hiring and new business formation and is yet another sign of economic malaise. At the heart of the issue is a housing market defined by exceptionally low inventory levels. Maryland’s Lack of Housing Inventory The pandemic gave rise to remote work, and in an economy where jobs aren’t tied to specific locations, workers will migrate to areas with ample affordable housing and low tax rates. Put simply, that is not the case in Maryland. In September 2019, two quarters before the start of the COVID-19 pandemic, there were more than 22,000 homes for sale in Maryland. At that point, inventory had already been trending lower for several years, having declined from nearly 32,000 active listings five years earlier in September 2015. As of September 2023, the most recent month for which data are available, there were fewer than 9,400 homes listed for sale in Maryland, 56% fewer than in September 2019. Over just the past year, active inventory has fallen by more than 3,000 units, a decline of nearly 24%. The lack of housing inventory is largely due to constraints on the production of new housing imposed by local governments, exacerbated by high interest rates, which have pushed mortgage rates to levels not seen in decades; the average rate on a 30-year fixed mortgage is currently at the highest level since the fourth quarter of the year 2000. At the turn of the century, however, mortgage rates had been trending lower for over 20 years. Those contemplating a move consider not only the prevailing level of mortgage rates, but also how those rates compare to the rate on their existing mortgage, leading to the so-called “lock-in effect.” During the early months of the pandemic, household finances were padded by stimulus payments and the lack of opportunities to spend. With the Fed easing interest rates, average mortgage rates reached a historic low by the third quarter of 2021. Households took advantage. Many moved, and more refinanced. As a result, the distribution of outstanding mortgage rates underwent an unprecedented shift. Fewer than 4% of outstanding mortgages had a rate below 3% during the first quarter of 2020. By the first quarter of 2022, that share had risen to 25%, by far the highest level on record. At that time, three in every four mortgages were locked in at a rate lower than 4%. Homeowners have been understandably reluctant to part with their low fixed rate mortgages, and even as of the second quarter of 2023, more than 60% of outstanding mortgages have a rate below 4%. On the flipside of that dynamic, the share of mortgages with a rate above 6% currently stands at 10.5%, half a percentage point lower than at the end of 2019. The Trouble for First-Time Homebuyers While many existing homeowners are content to stay put with their low fixed-rate mortgage, there has been a surge in household formation as the relatively large Millennial generation starts to build families and head to the suburbs, and that has bolstered demand from would-be first-time homebuyers. Not only are these households seeking to become homeowners, but they have also begun to accumulate the wealth necessary to make a down payment; Americans’ real median net worth expanded 37% from 2019 to 2022, the largest three-year increase on record, and those below the age of 35 experienced a particularly large increase in wealth. Despite this rise in net worth, however, first-time homebuyers are still being pushed out of the market by lack of housing options, elevated borrowing costs, and high home prices. The average sales price in Maryland has risen from about $344,000 in September 2019 to $474,861 in September 2023. That’s an increase of 37.9%, nearly double the rate of economywide inflation (19.9%) and more than five times the rate at which average hourly wages have increased in Maryland (7.2%) over that span. In other words, the law of supply and demand is alive and well. Assuming a 20% down payment on a purchase at the average sales price and mortgage rate, the regular monthly payment has increased from $1,267 in September 2019 to $2,579 in September 2023, an increase of 104%. But that understates the decline in affordability because the average rate on a 30-year fixed-rate mortgage increased from about 3.7% in September 2019 to about 7.2% in September 2023. Using the simple rule that housing costs should be no more than 30% of a household’s annual income, that raises the qualifying income from less than $51,000 to more than $103,000. It should also be noted that most first-time homebuyers are not making a 20% down payment; according to a Bankrate analysis of data produced by ATTOM Data Solutions, the average down payment in Maryland during the third quarter was just 11.9% of the purchase price. The Lack of New Home Construction and The Missing Middle Some aspects of Maryland’s affordability problem are unavoidable. Interest rates, for instance, are out of the state’s control. The crisis-level lack of supply, however, is something that could be—but hasn’t been—addressed by state and local policymakers. During the year ending in July 2023, Maryland issued just 15,511 authorizations for new residential construction. That’s the fewest in any twelve-month period since July 2017 and, on a per capita basis, ranks 40th among all states. Put simply, Maryland is not building enough new housing units to meet demand. That has caused prices to balloon and served as a significant headwind to economic growth; notably, Maryland’s population shrank last year while the state’s employment base remains below the pre-pandemic level. Perhaps the largest barrier to homeowner affordability in Maryland is missing middle housing, or the lack of units comparable in scope with single-family homes but at smaller sizes and price points. This includes townhomes, accessory dwelling units, duplexes, triplexes, and other similarly situated units. There is more than sufficient demand for these types of units, yet builders are unable to meet this demand due to overly restrictive zoning—and pushback from local homeowners opposed to higher density housing—in communities throughout the state. Some jurisdictions have started to take action to address this missing middle. The Abundant Housing Act, currently being considered in Baltimore City, would amend zoning regulations in some areas, while Montgomery County’s Thrive 2050 comprehensive plan and Howard County’s HoCo by Design general plan both advocate for more units to fill in the missing middle. Proposed legislation and plans may not be enough to facilitate the type of development needed to address the state’s housing needs, however. A recent study of similar efforts in Seattle, where zoning density regulations were reduced in some areas, but developers were also required to build a certain percentage of low-income units, found that development actually decreased in those specific areas yet increased in parts of the city not subject to the requirements. And some communities are actually moving in the opposite direction. A resolution currently being considered in Prince George’s County would restrict the number of units that can be authorized each year, especially in areas outside the beltway where there is the greatest demand for housing. If this resolution passes, it will exacerbate affordability in a county that has seen the average sales price increase 34.9% over the past four years. Looking Ahead The current expectation is that interest rates, while being near their cyclical peak, will remain higher for longer due to stubborn inflation and a still-hot nationwide economy. Mortgage rates are expected to come down during 2024, but likely not to a level that supports a significant uptick in existing home sales. While the nationwide economy continues to outperform expectations, there are an unusually high number of risks. Commercial real estate debt is coming due, and the beleaguered office market still represents a significant risk for the banking sector. Credit card debt remains low by pre-pandemic standards but is rising, and those that do fall into delinquency now face historically high interest rates. And then there’s ongoing political dysfunction and rising geopolitical uncertainty, both of which are particularly difficult to account for in economic forecasts but could negatively impact the economy in a number of ways. The upshot is that, barring an economic downturn, rates will likely remain too high in 2024 to facilitate a surge in homebuying activity in Maryland. When rates do drop, however, pent up demand will be released causing a large increase in transactions. In the longer term, Maryland must address barriers to building new residential units, especially with regards to the missing middle. If it fails to do so, the state’s economy will remain one defined by a shrinking population and anemic employment growth.