U.S. house prices are falling in inflation-adjusted terms, but that is not enough
Published in Housing Finance International Journal.
In the Winter 2025 issue of Housing Finance International, I predicted that average U.S. house prices must fall because they have gone to bubble levels – by two reputable calculations, to 30% over their long-term trend line, or 35% over being affordable on a pre-pandemic basis. In the spring of 2026, that prediction still looks good.
The house price inflation to the current extreme level was driven by the financial manipulations of the Federal Reserve, which in unprecedented fashion, made itself the biggest mortgage investor in the country by far. It bought up mortgage securities with newly printed money to amass a peak portfolio of the previously unimaginable amount of $2.7 trillion, thereby pushing down the interest rate on mortgage loans to exceptionally low levels – as low as 2.7%. In U.S. practice, that is the interest rate for a 30-year loan, with its interest rate fixed for the entire 30 years, but which is also prepayable without penalty at any time at the borrower’s option. The Fed made these very long-term fixed-rate loans abnormally cheap.
By making mortgage loans abnormally cheap, the Fed made houses abnormally expensive. By making houses abnormally expensive, it made them widely unaffordable once mortgage interest rates returned to normal, as they did and remain. Home sales fell to three-decade lows. The unaffordability of houses is now a major American political issue, exercising both the President and the Congress.
The effects on the Fed’s own finances and the government’s budget deficit are also unfortunate. The Fed’s mortgage portfolio still totals $2 trillion and is now far under water, with the most recently published mark to market disclosure showing a $323 billion market value loss. The $2 trillion pile of mortgages is also causing ongoing cash losses. Its average yield is about 1.45% less than the cost of the Fed’s deposits, so in current operating results the Fed is losing on its mortgages about $29 billion a year—these are also losses to the U.S. Treasury.
The Fed has decided, correctly, that it should bring its mortgage portfolio back to zero, where it always was for the first 95 years of the Fed’s existence, until 2008. But it does not want to sell the mortgages because of the massive market value loss it would have to realize to do so. Moreover, the Fed’s selling in any material amount would drive the price of mortgage securities down, pushing mortgage interest rates higher and making houses even less affordable. This would be politically damaging to be sure. So, the Fed is stuck with a slow run-off strategy and will maintain its mistaken role as a very large government housing bank for years to come.
Some political commentary suggests that the current unaffordability of American houses reflects that mortgage interest rates, now at about 6%, are too high. Of course, 6% seems high compared to the abnormally low rates the Federal Reserve created. But 6% is a normal U.S. mortgage interest rate, historically speaking, not a high one.
Over the last 55 years, from 1971 to now, American 30-year mortgages had an average rate of over 7%. They were over 6% for about 70% of that time. They have averaged about 1.5% to 2% over the yield of the 10-year U.S. Treasury note. Since that yield is now about 4.1%, that suggests a normal mortgage rate would be 5.6% to 6.1%. Over the long term, the 10-year Treasury has yielded on average 1.95% over inflation. With inflation at 2.7% for 2025, the 10-year Treasury would be 4.65% on historical average and the 30-year mortgage over 6%.
The problem is not that mortgage interest rates are too high, but that house prices are much too high. The solution is that they need to come down.
Of course, house prices can come down in two ways: in absolute or “nominal” terms, and in inflation-adjusted or “real” terms. As an example of the second, if nominal house prices go sideways while inflation continues, it reduces house prices in real terms. If nominal household incomes rise with inflation, they would be gaining on house prices and affordability would be improving. That might be a “soft landing” scenario for house prices. In the alternative, nominal house prices could fall on a national basis, as they did fall from 2007 to 2012.
According to the AEI Housing Center’s most recent report, national house prices increased in nominal terms by 1.5% for the twelve months to January 2026, failing to keep up with consumer inflation for those months of 2.4%. Thus, real house prices fell by 0.9%. At this rate, it would take about 29 years to correct a 30% real terms overshoot.
Viewing things on a six-month time horizon, nominal U.S. house prices as measured by the Case-Shiller 20-City Composite Home Price Index, not seasonally adjusted, fell in the second half of 2025 from an index value of 343 in June to 336.9 in December, for a six-month house price reduction of 1.8%, or an annualized rate of 3.6%. With an annualized rate of inflation for this period of 2.7%, real house prices on this index fell at an annualized rate of 6.3%. If prices falling at 3.6% nominal and 6.3% real continued, it would take about 4.4 years to offset a real 30% bubble overshoot.
There are, of course, regional differences in house price behavior. In many areas in the U.S. West and South, where house prices previously rose very rapidly, they are now falling. The Federal Housing Finance Agency reports that house prices in 2025 rose less than the year’s inflation, thus fell in real terms, in half of the 50 U.S. states and in Washington DC. They also fell in nominal terms in nine states, including the large states of California, Texas and Florida, and in Washington DC. The national total was a decline in real terms of 0.9%.
On the overall national trend, the outlook seems to be for house prices to continue falling at least in inflation-adjusted terms. However, a pure “soft landing” scenario probably moves too slowly to correct the house price bubble the Federal Reserve so mightily puffed up. It continues to appear that the U.S. can expect nominal house prices to fall on a national basis.
That will be good for affordability and good for home buyers, but not so good for those with highly leveraged home ownership or for those with lower-quality credit exposures to mortgages. The price giveth and the price taketh away.