After months of losing out on houses in their price range in Los Angeles' San Fernando Valley, Eric Schmeltzer and his wife upped their budget, considered neighborhoods miles outside their preferred location, and offered prices well over asking on homes they were not even sure they wanted.

"We were consistently outbid on everything," said Schmeltzer, a political consultant. "Even places that weren't even that nice, we were getting completely creamed on."

The last straw came in March when they offered $150,000 over the asking price for a home and it was not even close to the highest offer.

In May, Schmeltzer and his family plan to move into a rental home instead, save up some money and restart their housing search in a year.

If history is any guide, the Federal Reserve's plans to hike rates repeatedly throughout this year should cool the white-hot U.S. housing market, offering Schmeltzer, and hundreds of thousands of first-time homebuyers like him, some relief. Still, the dynamics of this particular market, with limited supply and historically high demand, will likely prove a difficult hurdle for Fed policy. When buyers are flooding the market with all-cash and offers 20% or more over asking prices, the market may have some near-term immunity to rising mortgage rates.

"The housing market is so supply constrained that the impact of rising mortgage rates will likely be less than it has been in the past," said Mark Vitner, a senior economist at Wells Fargo. "There are so few houses on the market today relative to buyers."

Imbalance impact

The Fed's rate hike push has already caused mortgage rates to surge. The average 30-year fixed-rate mortgage was at 5.11% on April 21, up 200 basis points since the start of the year and the highest rate since 2010.

With that higher rate, the monthly mortgage payment on the median asking price home rose to a record high of $2,318, a 38% increase from a year earlier when mortgage rates were 2.97%, according to Redfin, a real estate brokerage.

In the past, a rise in rates has weighed substantially on the housing market, which is arguably the most interest-rate sensitive segment of the U.S. economy, said Ronnie Walker, an economist at Goldman Sachs, in an April 18 note.

But the extreme imbalance between supply and demand will likely dampen the hit to the market from higher rates particularly since the nationwide housing vacancy rate is at 0.9%, the lowest level since 1978. This will likely allow home builders to continue to build even as rates rise.

"Housing starts have historically been unresponsive to changes in mortgage rates in a supply-constrained environment, likely because homebuilders are able to continue building with little fear that homes will sit vacant after completion," Walker wrote.

Supply constraints

Housing inventories are falling to their lowest levels in years. The number of existing single-family homes for sale in the U.S. was at 950,000 in March, down from 1.13 million in July, according to the National Association of Realtors. Meanwhile, the annual pace of single-family home construction was down in March about 4.4% from March 2021, according to the U.S. Census Bureau and U.S. Department of Housing and Urban Development.

"This is pretty unprecedented," said Danielle Hale, chief economist at realtor.com. "We're years behind on single-family housing construction."

Much of the supply constraint is due to rising construction costs, which have been driven up by the global supply chain crisis and the tight labor market that has reduced the availability of workers in the sector. There were 381,000 jobs openings in construction in February, up from 257,000 a year earlier, according to the Bureau of Labor Statistics.

Over the past two years, the price of lumber and copper has more than doubled and contractors are facing severe delays on deliveries of garage doors, microwaves, electrical equipment and a myriad of other construction inputs.

"It's not just that the prices are higher," said Robert Dietz, chief economist with the National Association of Home Builders. "It's taking longer for these materials to arrive at the worksite."

These factors may get worse before they get better even as the Fed boosts rates.

"Higher interest rates will cool off demand, but it doesn't address housing affordability challenges," said Dietz. "Higher interest rates do not produce more lumber, they do not produce additional skilled labor."

The NAHB/Wells Fargo Housing Market Index, a monthly survey that reflects the views of builders on conditions within the single-family housing market, has declined for the past four months. The index peaked in November 2020 when builders viewed the market most favorably.

The decline has not been significant, but Dietz said it does reflect views from builders that higher interest rates will eventually weigh on the market.

Even higher prices

Consumers expect home prices to rise 7% over the next year, but just 2.2% annualized over the next five years, according to a housing survey released April 18 by the Federal Reserve Bank of New York.

"Housing will remain strong — there's still a lot of pent-up demand out there — but activity will definitely slow later this year as higher rates start to bite," said Gus Faucher, chief economist at PNC Financial Services Group. "There's little chance that higher rates won't weigh on housing."

Monthly sales of new, single-family homes fell to 763,000 in March, down from the most recent peak of 993,000 in January 2021, according to government estimates. These new home sales have fallen every month since December 2021, a sign that the tight housing supply is keeping some buyers from closing deals.

The Fed's push for higher rates will likely "take some of the steam" out of the housing market, with some pullback already in the vacation home market and from some first-time homebuyers, Vitner with Wells Fargo said.

"Mortgage rates much above 5% will present a real hurdle for the housing market," Vitner said. "Rates as high as 6% or 7% would be devastating for the housing market."