House Prices: How Much Damage Will the Housing Market Do to the Economy?

Fears of a recession are rising as the economy is hit by higher energy prices and tighter monetary policy. While higher interest rates are bound to slow things down, this may be working too well in the housing sector, where the pandemic boom is stalling. Is the fall in housing going to push the slowdown in the economy to the limit? And could that recession have lasting structural consequences?

Downplaying the role and risk of housing in the economy is treacherous. In 2007, Ben Bernanke, then chairman of the Federal Reserve, said that housing problems “will probably be limited,” and at the time that may have been true. But the rapid transformation from limited to systemic risk in the mid-2000s reminds us that housing must be continually watched. Is it simply a headwind, a credible recession factor, or worse yet, a structural risk?

Monitoring these risks includes monitoring housing’s direct links to economic activity, its indirect impact on household finances, and its indirect links to the banking system. There are varying degrees of stress in all of these. However, while the slowdown in housing adds to a confluence of headwinds that could easily tip the economy into recession, it remains unlikely that there will be any further fallout in the sector.

Real estate activity could be more robust than you think

Housing has three direct links with economic activity (GDP): the construction of new houses, the remodeling of existing houses and that of housing transactions. Although all three will slow down and thus be a headwind to the cycle, the remodeling and new builds have a strong fundamental backdrop and may prove stronger than expected.

First, consider the activity associated with home sales (think broker fees, attorney fees, etc.), which contribute significantly to the GDP footprint of housing. Today, as in 2008, sales are falling from exceptionally strong levels. But the sudden stop in financing and the sustained change in credit standards that undermined housing transactions in 2008 is unlikely this time. Mortgage rates have skyrocketed, reducing the amount of home that can be purchased with the same payment, but financing is still available.

Next, spending on residential remodeling is running on up to 60 years. This speaks not only to the pandemic-induced need for more home office space. It also speaks to the strong balance sheets of households, where wealth has grown in the income distribution with the stimulus of the pandemic and the inability to spend freely. Although household wealth is under pressure, just think of the stock market crash, balance sheets are unlikely to be structurally affected this time.

Third, unlike in the mid-2000s, there simply isn’t enough housing available today. Today’s low housing inventories are consistent with continued construction activity even in a context of higher rates, because the risk of not being able to sell homes when few are on the market is lower.

The impact of housing on household finances appears mixed

Beyond actual activity, housing also has an impact on the economy because it is one of a household’s biggest assets and often its biggest expense. When home values ​​fall, that has a material impact on household wealth and confidence, and if the drop is large enough, it forces households to repair damaged balance sheets, weighing on investment and consumption. for an extended period. The 2008 crisis was an extreme version of this wealth effect and contributed to the slow recovery of the 2010s.

Today, home prices remain high and are likely to weaken, particularly given the rise in prices during the boom and the recent increase in mortgage rates. But the prospects of them leaving household balance sheets in a weak position relative to where they were before COVID-19 are less likely. This is due to the remarkably strong asset side of household balance sheets and because households have deleveraged substantially over the past decade. House prices are still important for household balance sheets, but the vulnerability is not the same today.

While balance sheets are likely to be resilient to housing stress, two additional household linkages are more negative. First, refinancing: When interest rates fell during the pandemic, households were able to refinance, lowering interest costs and freeing up income to spend elsewhere. Second, when rents and other housing costs rise, which means there is less income to spend elsewhere.

Today, each of these are obstacles to the economy. Substantially higher mortgage rates mean refinancing activity will be modest going forward, so very few households will have additional discretionary income to spend. And very tight housing inventories, a strong recovery and rising home prices and rents have helped drive the fastest growth in housing costs in decades, squeezing discretionary income.

the banks are fine

In one area of ​​the economy, housing linkages work in two directions: that of the banking sector. Housing is particularly affected by the flow of credit from the banking system (and the shadow banking system), and banks are particularly affected by the health of housing. In 2008, banks that were undercapitalized and overleveraged gave extraordinarily easy credit to overleveraged households.

When housing began to weaken and credit losses started a pernicious spiral of weaker housing leading to weaker banks, leading to tighter credit and weaker housing, the economy quickly found itself in a systemic crisis. This threatened to bring about a depression, but skillful, if too slow, political action to break the downward spiral helped stabilize the economy and a U shape recovery seized

Today, credit quality, access and financing costs look different. Unlike in 2008, delinquencies are low, nonperforming loans are few, and the banking system is in solid health with high levels of capital and profits. This has helped keep credit accessible, after a brief adjustment at the start of the COVID crisis, to the same types of borrowers who had access before COVID hit, even if that credit is now more expensive.

recession, or worse?

Today, it is true that many of the housing economic bonds are under significant pressure, a level of pressure that is unlikely to abate as rates may remain higher than they should be. have been in many years. And this pressure further increases the risk of a recession in the coming quarters as home sales plunge, refinancing stalls and builders feel pressured.

However, looking at the different linkages, the case for sustained weakness or systemic threat seems much weaker than in the last housing boom-bust cycle. Household balance sheets are extremely strong and real estate leverage is modest; credit standards have been healthy and there are few signs of credit stress; and the banks are profitable and heavily capitalized. Even builders feeling pressure from higher rates are likely to continue to build at a strong (if not as strong) pace as housing inventories are so low, a strong fundamental backdrop for construction that won’t change significantly quickly.

Although housing is a significant headwind, when considering recession risk, the key question must be what kind of recession could it be, rather than a binary question of whether or not a recession will come. And here the distinctions about the nature of housing risks are crucial. The good news is that the risks emanating from housing today are more related to other obstacles than a dramatic financial downturn. Don’t expect structural housing to deliver the lasting economic fallout that we saw the last time the market crashed.

Philipp Carlsson-Szlezak is Managing Director and Partner in BCG’s New York office and the firm’s Chief Global Economist.. Paul Swartz is director and senior economist at the BCG Henderson Institute in New York.

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