US Real Estate Prices Could Plunge 20%, “Severe” Recession Possible : Dallas Fed

US home prices made lofty gains over the pandemic—a bigger run up than the one seen before the Great Recession. It’s going to be difficult to not see a significant chunk of those gains given back to the market, warned the Dallas Fed. Researchers from the US Federal Reserve branch warn severe recession is still possible. They need to tread carefully, since falling home prices can set off a negative feedback loop for the economy.

US Real Estate Prices Present A Risk To Price Stability & Employment

The US residential real estate market has been out of control, and is finally slowing down. Home prices increased 94.5% from Q1 2013 to Q2 2022, still a 60.8% increase after adjusting for inflation. “The magnitude of the increase is even larger than that of the preceding housing boom, from first quarter 1998 to second quarter 2007,” said Fed researcher Enrique Martínez-García.  

He warns falling home prices pose a significant threat to price stability and employment. Helping to drive inflation is a 16% increase for rents in Q2 2022, which only slowed to 12.2% in Q3. He attributes this to the surge in home prices, trickling down through landlords. 

In general, shelter costs increased 6.2% in Q3, the strongest surge since the early 90s bubble. Since this drives inflation higher, it forces the central bank to act with higher rates. This will ultimately drive home prices lower.

It’ll Be Hard To Calm Inflation Without A House Price Spiral 

The Dallas Fed researchers mitigate factors that will help prevent more extreme action. They cite the backlog of new homes under construction as one factor that should help take some air out of the market. Higher mortgage rates will also help to cool excess demand. This will reduce the action needed from the central bank.

“In the current environment, when housing demand is showing signs of softening, monetary policy needs to carefully thread the needle of bringing inflation down without setting off a downward house-price spiral—a significant housing sell-off—that could aggravate an economic downturn,” he said.  

A Soft Landing Isn’t Guaranteed, and Will Be Hard To Achieve

A soft landing is now a common expectation, but those are a lot easier said than done, according to the Fed. High inflation requires significant policy rate increases, which will wear on debt-related consumption. Housing is a prime example of a segment vulnerable to these kinds of issues.

“Achieving a soft economic landing—taming inflation and avoiding a recession, as the Fed accomplished in 1994—cannot be taken for granted given that further monetary policy tightening can increase the household mortgage debt servicing burden and boost the odds of a severe house price correction,” said Martínez-García. 

In the Dallas Fed’s pessimistic scenario, household wealth can take a significant hit. They forecast real home prices fall 15%-to-20% in this case, shaving off 0.5%-to-0.7% of real personal consumption. “Such a negative wealth effect on aggregate demand would further restrain housing demand, deepening the price correction and setting in motion a negative feedback loop,” he warns. 

The Fed researcher stopped short of saying a “severe” housing bust can be avoided. However, he did emphasize it’s not easy to avoid one at this point. Even if it were possible, there are a completely different set of problems to consider. He points to rising inequality, resulting from a surge of wealth, tied to housing. Since younger generations tend to not own homes, they were left behind and a bigger gap formed. A severe recession or rising inequality. This doesn’t sound like much of a winning scenario for anyone.