Recession fears are escalating as the economy is hit by higher energy prices and tighter monetary policy. While higher interest rates are intended to slow things down, it may be working too well in the housing sector, where the pandemic boom is coming to a halt. Will a housing bust tip the slowing economy over the edge? 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 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 constantly watched. Is it just a headwind, a credible recession driver or – worse – a structural risk?
Viewing these risks includes looking at 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. But while the housing slowdown adds to a confluence of headwinds that could easily tip the economy into recession, a major fallout from the sector remains unlikely.
Housing activity could be more robust than you think
Housing has three direct links to economic activity (GDP): new housing construction, remodeling of existing housing, and housing transactions. Although all three will slow and thus be a headwind to the cycle, remodeling and new construction have strong fundamentals and may prove more robust than expected.
First, consider the activity associated with home sales—think broker fees, lawyers, etc.—which is a significant contributor to the housing GDP footprint. Today, as in 2008, sales are declining from unusually strong levels. But the sudden halt in financing and the sustained shift in credit standards that undermined housing transactions in 2008 is unlikely this time around. Mortgage rates have risen, reducing how much house the same payment will buy, but financing is still available.
Next, the costs of rebuilding homes are at their highest level in 60 years. This doesn’t just speak to the pandemic-induced need for more home office space. It also speaks to the strong balance sheets of households, where wealth has grown across the income distribution with pandemic stimulus and the inability to spend freely. Although household wealth is coming under pressure – just think of the decline in stock markets – balance sheets are unlikely to deteriorate structurally this time around.
Third, in a critical difference to the mid-2000s, there just isn’t enough housing supply today. Today’s low housing inventories are consistent with continued construction activity even against the backdrop of higher rates, because the risk of not being able to sell homes when there are few on the market is lower.
The impact of housing on household finances looks mixed
Apart from real activity, housing also affects the economy because it is one of households’ biggest assets and often their biggest expense. When house values fall, it has a significant impact on household wealth and confidence – and if the decline is large enough, it forces households to repair their damaged balance sheets, weighing on investment and consumption over a longer period. The 2008 crisis was an extreme version of this prosperity effect and contributed to the sluggish recovery of the 2010s.
Today, home prices remain high and are likely to weaken, especially given the rise in prices during the boom and the recent increase in mortgage rates. But the prospect of them leaving household balance sheets in a weaker position than where they were before COVID-19 is less likely. This is due to the remarkably strong asset side of household balance sheets and because households have shrunk significantly over the past decade. House prices still have an impact on household balance sheets, but the vulnerability is not the same today.
Although balance sheets are likely to be resilient to housing stress, two additional household connections are more negative. First, refinancing: As interest rates fell during the pandemic, households were able to refinance, lowering their interest costs and freeing up income to spend elsewhere. Second, when rents and other housing costs rise, it means that there is less income to spend elsewhere.
Today, each of these are headwinds to the economy. Significantly higher mortgage interest rates mean that refinancing activity will be modest going forward, so very few households will have extra discretionary income for consumption. And very tight housing inventories, a strong recovery and rising home prices and rents have all helped deliver the fastest growth in housing costs in decades – eating away at discretionary income.
The banks are okay
In one area of the economy, housing connections go 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, extraordinarily easy credit was extended to overleveraged households by banks that were themselves undercapitalized and overleveraged.
As housing began to weaken and credit losses started a devastating spiral of weaker housing that led to weaker banks, which led to tighter credit, which led to weaker housing, the economy quickly found itself in a systemic crisis. This threatened to produce a depression, but deft – if too slow – policy action to break the downward spiral helped stabilize the economy and a U-shaped recovery took hold.
Today, credit quality, access and financing costs look different. Unlike in 2008, defaults are low, non-performing loans are rare and the banking system is in robust health with high levels of capital and profits. This has helped keep credit available, after a brief tightening at the beginning of the COVID crisis, for the same type of borrowers who had access before COVID hit – even if credit is now more expensive.
Recession or worse?
Today, it is true that many of the housing economics are under considerable pressure – pressure that is unlikely to ease as prices may remain higher than they have been for many years. And this pressure further increases the risk of a recession in the coming quarters as home sales fall, refinancing stalls and builders feel squeezed.
But when you look at the different contexts, the argument for persistent weakness or systemic threat seems much weaker than in the last cycle of housing booms and busts. Household balance sheets are extremely strong and residential leverage is modest; credit standards have been healthy and there are few signs of credit stress; and banks are profitable and highly capitalized. Even builders who feel pressured by higher rates are likely to continue building at a strong (if not as strong) clip as housing inventories are very low, a strong fundamental for construction that will not change quickly.
While housing is a significant headwind, the key question when considering recession risk should be what type of recession it might be, rather than a binary question of whether or not a recession will come. And here the distinctions about the nature of the housing risk are decisive. The good news is that the risks emanating from housing today are more about amplifying other headwinds and not about a dramatic financial recession. Don’t expect housing to lead to the lasting structural economic consequences we saw the last time the market stalled.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.
The opinions expressed in Fortune.com comments are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Assets.
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