How the slowdown in homebuilding is affecting the Fed’s inflation and economic targets

  • US home sales continue to decline as Federal Reserve tightening pushes mortgage rates higher.
  • That has helped tame inflation, which is now retreating from four-decade highs.
  • But a slowdown in the real estate market also increases the risk of a recession.

Housing could become a key policy conundrum for the Federal Reserve.

Market activity has declined for nine straight months and home sales fell 28.4% year over year in October, according to the National Association of Realtors, with some economists warning that prices could fall 20% next year. when the broader slowdown kicks in.

While house prices need to soften somewhat for headline CPI inflation to be contained, a dramatic housing crash could also have a knock-on effect on the economy as a whole. And that would be another headache for the Fed, which has hiked rates six times this year to counter price pressures.

Here’s how the Fed’s tightening campaign has impacted the housing market – and why the sector could play a key role in Chair Jerome Powell’s ability to successfully lower rising prices without triggering a recession.

Why are home sales declining?

The Fed has raised borrowing costs by 75 basis points at each of its last four meetings in a row to fight inflation.

Aggressive 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.

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

“A drop in home buying is one of the by-products of tighter monetary policy,” David Doyle, chief economic officer at Macquarie, told Insider. “Housing is a rate-sensitive sector, so it’s not surprising that it has slowed significantly in the current context.”

What did the Fed say about the housing market?

So far, the Fed has shrugged off any talk that its rate hikes have hurt housing.

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

Still, some central bank economists have urged the Fed to pay more attention to home sales and prices as they begin to slow significantly.

“Monetary policy needs to carefully thread the needle to bring inflation down without triggering a downward spiral in house prices — a significant sell-off in real estate — that could exacerbate an economic downturn,” the Dallas Fed’s Enrique Martínez-García said last week.

How are falling house prices helping the Fed?

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

According to the S&P CoreLogic Case-Shiller US National Home Price Index, home prices posted their biggest increase in 34 years, up 18.8% last year — and so the central bank likely sees a way to bring inflation down by churning out some foam the market takes control.

But October’s CPI reading of 7.7% suggested that inflation is now slowly decelerating, which could give the Fed the leeway it needs to start easing its hawkish stance on interest rates.

“As mentioned above, we expect unemployment to rise and inflation to fall over the next year, which should in all likelihood prompt the Fed to reverse course and ease monetary policy through rate cuts,” said economists Charlie Dougherty and Patrick Barley of Wells Fargo in a recent research note.

Could the slowdown trigger a recession?

But the central bank needs to time such a policy shift — too much tightening could drag down housing market activity and accelerate a potential recession next year.

That’s because housing has a multiplier effect on the economy, generating income for real estate agents, decorators, and other industries involved in the sales process.

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

“Eventually this should spill over and affect job growth and the labor market,” Macquarie’s Doyle told Insider. “That’s partly why we expect a recession in 2023.”

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