Falling house prices will help the Fed keep inflation under control, but it will also increase the risk of a prolonged economic slowdown

• US home sales extend their decline as Federal Reserve tightening pushes mortgage rates higher.
• This has helped bring inflation under control, which is now receding from four-decade highs.
• But a slowdown in the real estate market also increases the risk of recession.

Housing could be poised to become a key political headache for the Federal Reserve.

Market activity has fallen 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 20 % next year as the general slowdown begins.

While house prices will need to slow for headline consumer price index inflation to be brought under control, a dramatic housing crash could also have a ripple effect on the economy as a whole. And that would cause another political headache for the Fed, which has raised interest rates six times this year to fight price pressures.

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

Why are home sales falling?

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

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

Rising mortgage rates tend to deter potential buyers as they make home loans more expensive.

“A decline in home purchases is one of the by-products of tighter monetary policy,” Macquarie chief economics officer David Doyle told Insider. “Housing is an interest rate sensitive sector, so it’s no surprise that it has slowed significantly in the current environment.”

What did the Fed say about the real estate market?

So far, the Fed has ignored any rumors that its rate hikes have had a negative effect on housing.

Powell said last month that the market “is likely to undergo 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 called on the Fed to pay more attention to sales and home prices as they begin to slow significantly.

“Monetary policy must carefully thread the needle to bring inflation down without triggering a downward spiral in house prices – a massive sell-off of homes – that could make an economic downturn worse,” Enrique Martínez said last week. Garcia of the Dallas Fed.

How are falling house prices helping the Fed?

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

Home prices saw the biggest increase in 34 years of 18.8% last year, according to the US national S&P CoreLogic Case-Shiller home price index – and so the central bank is likely seeing some pullback. market scum as a means of reducing inflation control.

But October’s CPI print of 7.7% suggested that inflation is now starting to ease, which could give the Fed the leeway it needs to begin to temper its hawkish stance on interest rates. ‘interest.

“As mentioned earlier, we expect unemployment to rise and inflation to fall over the next year, which should in all likelihood prompt the Fed to reverse the trend and ease monetary policy by reducing interest rates. rate,” said Wells Fargo economists Charlie Dougherty and Patrick Barley. in a recent research note.

Could the slowdown cause a recession?

But the central bank will need to set the timing for such a policy shift, as excessive tightening could lower housing market activity and hasten a possible recession next year.

Indeed, 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 were to remain too high for too long, these industries risk facing a drop in activity at a time when monetary tightening is already compressing their cash flows.

“Eventually this should boil over and start to impact job growth and the labor market,” Macquarie’s Doyle told Insider. “That’s part of why we’re predicting a recession in 2023.”