Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching Housing Affordability Ratios
Transcript
- Lucas: Central banks are in the habit of watching a lot of lagging indicators — core PCE, the employment cost index, that sort of thing. But there's one leading indicator that's been flashing red for a while now, and it's getting more attention inside central banks than it used to: the housing affordability ratio. Luna: You mean the classic metric — median home price divided by median household income? Lucas: Exactly that. The National Association of Realtors publishes a Housing Affordability Index, and as of early 2026, it's still hovering near the lows we saw in 2024 — levels not seen since the mid-1980s. Back then, mortgage rates were in the teens. Today, they're around 6.5 to 7 percent, but the price to income ratio has expanded so much that affordability is actually worse. Luna: So the Fed cares about this because... it feeds into inflation expectations? Or is it more about financial stability? Lucas: Both, but the channel that's most relevant right now is the rent channel. When people can't afford to buy, they keep renting, which pushes up rents. And rent feeds directly into the inflation measures the Fed targets — about 30 percent of the CPI basket and an even bigger share of core services inflation. Luna: Right, the shelter component. And that's the part that's been sticky. Lucas: Exactly. But there's a twist: the affordability ratio also tells you something about future home sales and construction. When affordability is this compressed, transaction volumes drop, and builders pull back on new starts. That eventually slows the pipeline of new supply, which keeps rents elevated for longer. So you get this feedback loop: high rates hurt affordability, which reduces supply, which keeps prices high, which keeps inflation sticky. Luna: And the Fed's hands are somewhat tied, because cutting rates too early could reignite home prices and undo any progress on affordability. Lucas: That's the delicate balance. Let me give you a concrete number. The NAR index hit 93 in 2024 — historically, anything below 100 is considered poor affordability. For context, during the housing bubble in 2006, it was around 100. During the early 2000s, it was often above 130. So 93 is genuinely extreme. Luna: So the Fed is basically watching the housing market as a canary in the coal mine for both inflation and financial stability. But do they actually have a target for this? Or is it just an input? Lucas: It's an input, not a target. The Fed doesn't formally target housing affordability. But several Fed presidents have started citing it in their public remarks. Minneapolis Fed President Neel Kashkari has been particularly vocal, linking affordability to the neutral rate of interest — the idea that if housing is unaffordable, the neutral rate might actually be lower than models suggest, because higher rates do more damage to the economy through the housing channel. Luna: That's a really interesting argument. So if the neutral rate is lower, then the current policy rate is tighter than it looks. Lucas: Right. And that changes the calculus on when to cut. The standard view is that the neutral rate rose after the pandemic — maybe to 3 to 3.5 percent. But if you adjust for housing affordability, you might argue that the actual neutral is closer to 2.5, meaning the current fed funds rate of 4.5 to 4.75 is more restrictive than the headline number suggests. Luna: So that would support the case for a rate cut sooner rather than later. Lucas: It does, but here's the counterargument: cutting rates could itself worsen affordability by reigniting home price appreciation. That's the bind. And it's one reason why the Fed has been so cautious in 2025 and 2026 — they're worried about reigniting the very pressure they're trying to contain. Luna: It sounds a bit like the Fed is stuck in a housing trap of its own making. I mean, low rates caused the pandemic housing boom, then high rates crushed affordability, and now they can't cut without risking another boom. Lucas: That's a fair way to frame it. But there's another layer: the affordability ratio also matters for the transmission of monetary policy through the wealth channel. When housing is unaffordable, younger households are locked out of homeownership, which means they don't benefit from equity appreciation, and their consumption is more sensitive to interest rates. So the economy becomes more rate-sensitive overall. Luna: And that would make the Fed's job harder — or at least, it makes the lags more unpredictable. Lucas: Exactly. And lags are the thing that keeps central bankers up at night. Because if you're wrong about how fast the housing channel transmits, you could easily over-tighten or under-tighten. Luna: We talk a lot about central bank credibility on this show, and I think a show like this — one that helps people understand the thinking behind the numbers — costs maybe a couple of dollars a month to produce per listener. And honestly, if you've gotten something out of these episodes, it genuinely makes a difference. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, Luna's right. It's not a big ask — just a small contribution if the show has helped you make sense of the economy. And it keeps us ad-free, which we like. Luna: Right. So back to the housing channel — one specific data point I've been watching is the Fed's own Senior Loan Officer Opinion Survey, which shows that banks have been tightening mortgage lending standards for nine consecutive quarters as of mid-2026. That's a record stretch. Lucas: That's a great point. And tightening standards compound the affordability problem. Even if rates come down, if banks are requiring higher credit scores and larger down payments, the effective affordability doesn't improve as much. So the ratio itself might understate the true constraint. Luna: So what does the Fed actually do with this information? They can't directly control lending standards — that's more of a regulatory tool. Lucas: Right, but they can signal that they're aware of the issue. In the FOMC minutes from the past few meetings, there's been increasing mention of housing market conditions. In the March 2026 minutes, the word 'affordability' appeared four times — that's up from zero in 2023. That's a real shift in language. Luna: But language doesn't put a roof over anyone's head. Lucas: No, but it shapes expectations. And expectations matter. If the Fed signals that it understands the housing constraint, it can influence long-term rates and mortgage spreads without actually moving the policy rate. That's the expectations channel at work. Luna: So the housing affordability ratio is really a leading indicator for the Fed's own thinking — a way to calibrate how tight policy actually is. Lucas: Exactly. And I think we're going to hear a lot more about it in the second half of 2026, especially if the data continues to show that the rental component of inflation is not coming down as fast as the Fed hoped. One number to watch: the CPI shelter index was still running at about 4.5 percent year-over-year as of June 2026, even though market rents have been flat for months. That lag is partly driven by the fact that homeowners' equivalent rent is based on a survey, and that survey has been slow to reflect the affordability-driven shift in demand. Luna: So the affordability ratio is really the canary in the coal mine for that lag. If affordability stays this low, the lag could persist for another year or more. Lucas: That's the risk. And it's one reason why some economists argue that the Fed should be more aggressive in cutting rates — not to boost housing, but to avoid a deeper downturn. The housing channel is powerful, and if it seizes up, the whole economy suffers. Luna: So where does that leave us for the next FOMC meeting in September 2026? Do you think the affordability data pushes them toward a cut? Lucas: I think it increases the probability, but it's not decisive on its own. The Fed will also be watching core services ex-housing, wage growth, and productivity. But if I had to pick one metric that's underappreciated by the market, it's this one. The housing affordability ratio is telling us that the economy is more fragile than the headline GDP numbers suggest. Luna: So maybe the next big move from the Fed will be driven not by a recession or a stock market crash, but by a slow-burn housing affordability crisis. Lucas: That's exactly the kind of scenario that keeps central bankers humble. It's not always a dramatic event — sometimes it's just the compounding weight of a single ratio that tips the balance.