While falling mortgage rates will improve affordability, the "lock-in effect" for existing homeowners with ultra-low rates will persist. This will suppress the typical sales volume rebound, leading to an anemic 3% growth in purchase volumes, a historically tepid response to improved affordability conditions.

As mortgage rates fall, more homeowners will list their properties, increasing inventory. This rise in supply will happen concurrently with the rise in demand from improved affordability. This dynamic will prevent a surge in home prices, keeping annual appreciation capped at a modest 2% for the upcoming year.

The difference in home price trends between US regions is not about weather or jobs, but housing supply. States in the South and West that permit widespread new construction are seeing prices fall, while "Not In My Backyard" (NIMBY) states in the Northeast and Midwest face shortages and rising prices.

A sustainable recovery in housing activity requires a roughly 10% improvement in affordability. Morgan Stanley calculates this threshold will be met when mortgage rates fall to approximately 5.5%, a specific target needed to meaningfully "unstick" the market from its current low-activity state.

With high interest rates freezing the existing home market, homebuilders are successfully competing by using their own margins to "buy down" mortgage rates for customers. This strategy allows them to continue selling inventory even when affordability is broadly challenged.

To address the housing supply crisis, policymakers should index the capital gains tax exclusion for home sales to inflation. The current thresholds, unchanged since 1997, create a disincentive for long-term homeowners to sell. Adjusting the exclusion would incentivize downsizing, releasing existing housing stock onto the market for new buyers.

A significant housing market recovery requires a substantial and sustained improvement in affordability. Analysts estimate a 100-basis-point drop in mortgage rates (e.g., to 5.5%) is needed to trigger a meaningful pickup in sales. However, this growth is not immediate; sustainable increases in sales volumes typically materialize a full year after the affordability improvement occurs.

A major driver of today's housing scarcity is that homeowners, particularly Boomers, who refinanced into sub-3% mortgages have no financial incentive to ever sell. This seemingly positive economic condition has had the negative side effect of locking vast amounts of housing inventory in place, worsening the supply crisis.

The gap between existing mortgage rates (under 4.25%) and new rates (over 6.25%) is over 200 basis points. This spread, which disincentivizes homeowners from selling, has persisted for three consecutive years. Historically, the gap only exceeded 100 basis points for a total of eight quarters over the past four decades, making the current situation a major anomaly.