Housing market cools — will prices follow?

With inflation stubbornly high, the Federal Reserve is pumping the breaks on the economy by raising interest rates. The reasoning is when interest rates rise, demand wanes, activity slows and prices start to moderate — and then eventually fall. Easy, right?

Unfortunately for the central bank, inflationary cycles are tough to break, and rising rates take a while to filter through the economy. (Separately, the Fed can do little to ease supply constraints, but those do appear to be loosening.)

Behavior in the residential real estate market may be the Fed’s best hope for a soft landing — meaning a slowdown that avoids a full-blown recession — for the economy.

To recap, amid the pandemic, a deluge of buyers seeking more space and armed with cheap mortgages rushed into the housing market. With inventory levels low and activity high, prices soared.

That scenario played out in the broader economy, as consumers unleashed their pent-up demand and drove prices higher, first in the goods part of the economy and now in the services side.

While the Fed does not control longerterm interest rates associated with most mortgages, all rates have been increasing. A year ago, a 30-year fixed-rate mortgage was just over 3% (near the all-time low); today, it has more than doubled to almost 7%, near a 20-year high.

At last year’s 3.2% rate, the monthly payment for a $400,000 house, with 20% down and a 30-year fixed rate, was $1,384 for principal and interest; today, the cost increases to $2,130. Put another way, the buyer who could afford a $450,000 house a year ago must drop down to $345,000 because of rate increases.

Higher rates and prices have put the recent real estate acceleration into neutral. According to Redfin, “Housing-market activity is plunging further this fall than it did over the summer as mortgage rates near 7% ... . Price drops have reached a record high, and home sales and new listings are dropping.” The National Association of Realtors (NAR) reported existing home sales slid in September and are down 23.8% from a year ago.

The situation is impacting both buyers and sellers, with the former forced to remain on the sidelines amid a competitive rental market, and the latter who are unwilling to list their homes and give up their low mortgage rates, contributing to a decline in new listings (down 17% from a year ago).

While home prices are not dropping precipitously, they are decelerating. In September, the median existing-home price was $384,800, an 8.4% increase from a year ago ($355,100), but down from the record high of $413,800 in June.

Sam Hall of Capital Economics expects that prices overall will fall by 8% from the June peak over the next year. There is more evidence that the real estate frenzy is abating: Fewer homes are selling above their list price; seller price drops are increasing; and the time of a home staying on the market is rising to a median of 33 days, “up more than a full week from 25 days a year earlier and the record low of 17 days set in May and early June,” according to Redfin.

The Fed is likely hoping that the housing market slowdown will echo across various parts of the economy.

If so, the central bank just might get its soft landing. Then again, considering that residential investment is a large part of the nation’s economy, any significant slowdown in the housing market could also increase the risk of a recession in the coming year. The Fed’s window of opportunity is closing quickly.