Falling home prices will help the Fed tame inflation — but they also raise the risk of a prolonged economic deflation

Housing may be about to become a major Fed policy conundrum.

Market activity has been down for nine straight months and home sales fell 28.4% in October from a year earlier, according to the National Association of Realtors, with some economists warning prices could fall as much as 20% next year as a broader slowdown begins.

While house prices will need some moderation so that headline CPI inflation can be reined in, a dramatic collapse in real estate could have a detrimental effect on the economy as a whole. This would cause a new headache for the policy of the Federal Reserve, which has raised interest rates six times this year to combat price pressures.

Here’s how the Fed’s monetary tightening campaign has affected the housing market — and why the sector can play a key role in determining whether Chairman Jerome Powell can successfully lower high prices without causing a recession.

Why are home sales declining?

The Fed has boosted borrowing costs by 75 basis points at each of its last four consecutive meetings to fight inflation.

Strong monetary tightening has lifted the average 30-year US mortgage rate from 5.60% to 6.84% over the past three months, according to Bankrate.

Higher mortgage rates tend to deter potential homebuyers because they make home loans more expensive.

“The decline in home buying is a by-product of monetary tightening,” said David Doyle, Macquarie’s head of economics. “Housing is an interest rate sensitive sector, so it is not surprising that it has slowed materially in the current context.”

What did the Fed say about the housing market?

So far, the Fed has brushed off any talk that its interest rate increases have negatively impacted housing.

Powell said last month that the market “has to go through a correction” after a combination of pandemic-era fiscal stimulus and tight supply fueled a housing bubble last year.

However, some central bank economists have called for the Fed to pay more attention to home sales and prices when they start to slow dramatically.

Enrique Martinez Garcia of the Dallas Federal Reserve said last week: “Monetary policy needs to carefully hammer the needle in lowering inflation without triggering a downward spiral in house prices – a massive housing sell-off – that could exacerbate deflation.”

How does falling house prices help the Fed?

The Fed’s main priority right now is to tame inflation, which is still well above its 2% target.

Home prices saw their largest increase in 34 years – 18.8% last year, according to the S&P CoreLogic Case-Shiller National Home Price Index in the US – so the central bank is likely to see removing some of the foam from the market as a way to reduce inflation. control.

But a CPI reading of 7.7% in October suggests that inflation is now starting to slow, which could give the Fed the necessary room to start easing its hawkish stance on interest rates.

“As mentioned earlier, we expect unemployment to rise and inflation to subside over the next year, which should prompt the Fed to reverse course and ease monetary policy by cutting interest rates,” said Charlie Dougherty and Patrick Parley, economists at Wells Fargo. In a recent research note.

Can an economic slowdown cause a recession?

But the central bank will need to time such a pivotal policy – because excessive tightening could depress housing market activity and accelerate a possible recession next year.

That’s because housing has a ripple effect on the economy, generating income for real estate agents, interior designers, and other industries involved in the sale.

If borrowing costs remain too high for too long, those industries risk facing a decline in business at a time when monetary tightening is already squeezing their cash flows.

“Ultimately, this has to spill over and start to impact job growth and the labor market,” said Macquarie’s Doyle. This is partly why we expect a recession in 2023.”


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