Central bank policymakers are trying to tame inflation while avoiding a deep recession. The home market could throw a wrench in those plans.

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As Federal Reserve officials try to grind persistently high inflation to a halt, they’re also hoping to achieve a “soft landing” for the economy that staves off the risk of a significant recession.

But as central bank policymakers look to ward off both of these undesirable outcomes, the nation’s housing market may hold the key to what happens next, according to an analysis this week by a Federal Reserve Bank of Dallas researcher..

If, for example, U.S. home prices drop by 15 percent to 20 percent in the coming months, it could cause a 0.5 percent to 0.7 percent drop in U.S. consumer spending, according to the new report.

A drop in spending this steep would likely further drag down demand for homes, creating what economists refer to as a “negative feedback loop,” Senior Research Economist Enrique Martínez-García wrote.

“This unprecedented pandemic boom poses an outsized risk for the U.S. economy, pressuring housing rents and, consequently inflation, higher,” Martínez-García wrote. “The possibility of a sharp price correction leading to an economic contraction — were one to materialize — would further complicate Federal Reserve inflation-fighting efforts.”

Still, a deep recession next year caused by a steep correction in home prices remains a mere worst-case scenario. It’s far from a foregone conclusion, Martínez-García believes.

“Although the situation is challenging, there remains a window of opportunity to deflate the housing bubble while achieving the Fed’s preferred outcome of a soft landing,” Martínez-García wrote. 

That soft landing is more likely if a double-digit drop in home prices can be avoided, he added.

But a downward pressure on prices is well underway. 

Mortgage rates have more than doubled in recent months, rising from historic lows below 3 percent last year to present values near 7 percent. As a result, home transactions have plummeted year over year, and the breakneck price growth that occurred earlier in the COVID-19 pandemic has since subsided and even reversed.

At the same time, many unsold homes are under construction, which provides more inventory for homebuyers to choose from.

All of these factors could serve to get inflation back down within the Fed’s goals. The impact of all of the changes won’t be felt right away by every U.S. household, though.

“The full effect of the ongoing tightening on households — including ultimately restraining housing demand — will take some time to be felt as the outstanding pool of mortgages gradually incorporates more of the recent vintages at higher rate,” Martínez-García argues in the report. 

As home prices come down, it will also lead to a reduction in personal wealth for many homeowners. But households appear to be better positioned to manage such a drop in equity today than they were heading into the housing crash of 2007.

Adjusted for inflation, home prices in the second quarter of 2022 were 24 percent higher than they were in the first quarter of 2020, the report points out. That’s a lot of recently acquired equity for longtime homeowners to fall back on if prices fall substantially.

But even though the Fed believes that a soft landing that curbs inflation and avoids a recession is possible, it’s a hope that “cannot be taken for granted,” Martínez-García wrote, especially if inflation proves persistent and makes the Fed take more aggressive steps.

“Further monetary policy tightening can increase the household mortgage debt servicing burden and boost the odds of a severe house price correction,” the report reads.

Email Daniel Houston

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