Freddie Mac's economists used this month's Economic and Housing Market Outlook to look at three areas of supply and demand.  Analyzing each, they say, will help us understand the direction in which we are moving and each is critical to keeping the housing recovery not just going but growing.  And in each of these fundamental areas, mortgage rates, home sales, and household formations, what we expect to be happening, isn't.

Frank Nothaft, chief economist, and deputy chief Leonard Kiefer point out that over the past five months the Federal Reserve has gradually tapered the growth of its holdings of mortgage-backed securities (MBS) that it acquired through three rounds of quantitative easing.  For May 2014 the Fed planned to hold growth in its holdings to $20 billion, one-half of what the monthly pace had been from the start of the third round (September 2012) through the end of 2013. 

Despite this curtailment, mortgage rates have largely held steady with fixed-rates even dipping in early May to levels last seen in November.  This happened because the Fed tapering has coincided with a sharp reduction in mortgage originations and thus new MBS issuances.  In fact, the ratio of the Fed's MBS acquisitions to new issuances is slightly higher than a year ago.  In other words, the Fed's 'demand' for new MBS has declined less than has new 'supply'. This is one reason the primary market is currently enjoying lower than expected mortgage rates.  New MBS will continue to run below that of last year because of the sharp decline in refinancing which is down from about 80 percent of the dollar volume of mortgages in January 2013 to 43 percent last month and is expected to decline further.  Freddie Mac's economists expect to see the 30-year fixed-rate mortgage gradually rise to around 4.6 percent by the end of the year as the Fed continues to 'taper' and ultimately reduces its share of new MBS issuance.

Home sales are also contrarian.  Even as sales have declined, prices have continued to rise.  Many real estate agents are reporting relatively low inventories of homes for sale and even with fewer of them selling, the inventory remained at only a 5.2 month supply in March and when new homes are included in the count, the total number of homes for sale relative to the number of households in the U.S. has been running at the lowest level in more than 30 years.  This low inventory reflects several features of the market.  First, many homeowners are underwater and reluctant to sell, especially since Congress has allowed the Mortgage Forgiveness Debt Relief Act to expire making them libel for taxes on any forgiven debt in a short sale.  Second, the majority of homeowners with a mortgage either bought or refinanced during the last few years and have such low interest rates they may be reluctant to sell and rebuy in a higher rate market. Third, while it varies by location, REO sales have slowed considerably over the past couple of years.

A decline in the number of homes offered for sale at each price point over the past year is consistent with the trend in the number of sales and in house prices: A supply-constrained market (holding other factors constant) will result in a decline in the volume of sales and an increase in real transaction prices (that is, house prices rising faster than inflation for all other goods). Thus, even though existing home sales are down 6.3 percent during the first quarter of 2014 compared with a year ago, house prices are up 8 percent in the Freddie Mac House Price Index, and even more in some other price measures.

While housing starts are up substantially from their 2009 trough they are still at depressed levels and one factor constraining new construction has been the "lackluster" rate of household formations which have averaged barely better 500,000 each year since the Great Recession, half of the pace in the previous decade.  Harvard's Joint Center for Housing Studies is projecting an average of 1.2 to 1.3 million per year over the 2015 to 2025 decade. Household formations are traditionally the largest driver of the demand for new housing; thus, when demand is weak, net new supply will be reduced as well.

Two principal forces affect household formation, demographics and the business cycle.  The demographic component is currently favorable - the number of live births in the U.S. began to increase around 1990 and peaked in 2007 so a rising number of young households should be arriving in the housing market.  However the protracted weak labor market has meant that many adults have continued to live with relatives or have returned to school.  Many have also accrued considerable student debt in the process. 

The economists say that a pickup in household formations will require stronger job growth.  "We understand that we might sound like a broken record here, but the need to have a job before buying a house is a simple fact of life."  April's job report was encouraging, with 288,000 jobs added to the economy and Nothaft and Kiefer project economic growth accelerating to about a 3.0 percent annualized rate in the final three quarters of 2014. "If we reach that level it should generate between 200,000 and 250,000 jobs per month, and with that an increase in net household formations and new housing starts-or in other words, additional housing supply. If we get that, we'll be able to address the underlying 'supply' problem because we know the 'demand' for housing is there.