Will housing provide clues about the economy?

The toxic combination of a four-decade high inflation and the Federal Reserve’s start to an aggressive interest-rate hike campaign has increased the odds of a recession within the next year.

Even if the National Bureau of Economic Research Business Cycle Dating Committee does not officially make a recession call, it is becoming obvious that a slowdown from last year’s zippy growth of 5.5% (the fastest GDP since 1984) has begun.

If we do see a recession, it’s hard to know how bad it will be or how long it might last.

For example, the COVID-19 downturn lasted just a few months, but job losses were steep, with unemployment peaking at 14.7%. Conversely, the Great Recession started in December 2007 and lasted until June 2010, and unemployment topped out at 10%.

Adding to the confusion is the unique nature of the pandemic, which created an extra layer of emotions to the economic outlook. After being cooped up for the better part of two years, Americans have been willing to spend briskly, despite higher prices.

Still, most economists predict that as people spend down their excess pandemic savings and incomes adjusted for inflation turn negative, consumers will be forced to tighten their purse strings and economic activity will peter out.

The current housing market may provide clues as to what we can expect from the overall economy.

Existing-home sales in May fell by 3.4% from April to a seasonally adjusted annual rate of 5.41 million. Sales were down 8.6% from a year ago and now “have essentially returned to the levels seen in 2019 — prior to the pandemic — after two years of gangbuster performance,” said National Association of Realtors chief economist Lawrence Yun.

But there is a lag between a slowdown in activity and a drop in price. In fact, the median existing-home sales price exceeded $400,000 for the first time and now stands at $407,600, a 14.8% increase from a year ago. However, the near doubling of mortgage rates to 6% means that sales are likely to keep sliding and prices should eventually follow.

Unfortunately, the period between now and when prices fall will keep first-time buyers on the sidelines.

Capital Economics notes that “at 6%, the median income household looking to buy the median-priced home today will have to put close to 25% of their income toward mortgage payments, higher than the previous record of 24% seen in the mid-2000s.”

The lack of affordability has pushed the share of first-time buyers to a 13-year low. Unfortunately, these frustrated house hunters will have to wait it out until either prices come down or rates retreat, or ideally, a combination of the two.

And therein lies a potential path for the overall economy.

It is possible, if not likely, that economic activity will slow down before we see a meaningful drop in prices.

Economist Mohamed El-Erian notes that although the Fed and other global central banks are increasing interest rates to contain inflation, “most have acknowledged that they started too late and are now playing catch up.” That means that inflation could remain higher for longer, which “threatens livelihoods, worsens inequality and undermines financial stability.”

The warnings about the future are coming from lots of different voices: Treasury Secretary Janet Yellen (“I expect the economy to slow”), Goldman Sachs (“We now see recession risk as higher and more front-loaded”), and Elon Musk, who has “a super bad feeling” about the economy.

Bottom line: It’s time to prepare for what could lie ahead.