“I’d say if you are a homebuyer, somebody or a young person looking to buy a home, you need a bit of a reset. We need to get back to a place where supply and demand are back together and where inflation is down low again, and mortgage rates are low again,” Powell told reporters at the time.
In the months since, economists have openly questioned what Powell meant by a housing “reset.” Does the Fed simply want buyers to back off long enough to allow inventory to rise? Or does “reset” mean the Fed also wants home prices—which spiked 43% in just over two years—to come down?
“When I say reset, I’m not looking at a particular specific set of data. What I’m really saying is that we’ve had a time of a red-hot housing market all over the country, where famously houses were selling to the first buyer at 10% above the ask even before seeing the house. That kind of thing. So there was a big imbalance between supply and demand. Houses were going up at an unsustainable fast level. So the deceleration in housing prices that we’re seeing should help to bring prices more closely in line with rents and other housing market fundamentals. That is a good thing. For the longer term what we need is supply and demand to get better aligned so that housing prices go up at a reasonable level and at a reasonable pace and that people can afford houses again. We probably in the housing market have to go through a correction to get back to that place. There are also longer-run issues with the housing market. As you know, it is difficult to find lots now close enough to cities, so builders are having a hard time getting zoning and lots and workers and materials and things like that. But from a business cycle standpoint, this difficult [housing] correction should put the housing market back into better balance,” Powell told reporters on Wednesday.
While Powell didn’t give a straightforward answer, he provided us clues as to where the Fed’s housing “reset” will take the US housing market.
1. We’re in a “difficult [housing] correction”
Not long after the Federal Reserve began applying upward pressure this spring on interest ratesthe housing market flipped into cool-down mode. While the slowdown started out mild, it has since intensified. On a year-over-year basis, new home sales and existing home sales are now down 29.6% and 19.9%.
That sharp housing slowdown isn’t a normalized market—it’s a housing correction. At least that’s according to Powell.
“For the longer term what we need is supply and demand to get better aligned so that housing prices go up at a reasonable level and at a reasonable pace and that people can afford houses again. We probably in the housing market have to go through a correction to get back to that place,” Powell said on Wednesday. “This difficult [housing] correction should put the housing market back into better balance.”
This housing correction, of course, has already started. Back in May, Moody’s Analytics chief economist Mark Zandi told fortune that spiking mortgage rates coupled with frothy home prices would push the US housing market into a housing correction. A housing correction being a period where the housing market—which got priced at 3% mortgage rates—would work towards equilibrium. As homebuyers pull back, Zandi says the housing correction will see inventory levels rise and home sales volumes fall. It would also, he said, put much of the nation at risk of falling home prices.
2. The housing “correction” puts downward pressure on home prices.
While Powell didn’t come out and say it, many housing analysts believe the Fed’s housing “reset” is code for home prices to drop. A view also shared by fortune.
“Clearly the Fed’s shift in word choice from June’s ‘housing needs a reset’ to today’s ‘housing reset actually means a correction’ indicates they are quite fine with home prices falling, home sales cooling off, and construction pulling back significantly in order to achieve their mission,” Rick Palacios Jr., head of research at John Burns Real Estate Consulting, tells fortune.
Already, we’ve seen housing markets across the West slide into home price corrections. According to Zillow, 117 regional housing markets saw home value declines between May 2022 and August 2022. This includes high-cost tech hubs like San Jose (down 10.6%) and San Francisco (down 7.8%). It also includes bubble markets like Austin (down 7.4%), Boise (down 5.3%), Denver (down 4.3%), Las Vegas (down 2.3%), and Phoenix (down 4.4%).
The reason we’re vulnerable to falling home prices is pretty simple. The Pandemic Housing Boom saw home prices across the country soar far above what incomes would historically support. In some markets, like Phoenix and Las Vegas, it mirrors levels they hit during the ’00s housing bubble. On Wednesday, Powell told reporters that the housing correction could help to balance those fundamentals.
“The longer that [mortgage] rates stay elevated, our view is that housing is going to continue to feel it and have this reset mode. And the affordability resetting mechanism right now that has to happen is on [home] prices. And so there are a lot of markets across the country where we’re forecasting that home prices are going to fall double digits,” Palacios tells fortune.
3. The housing “correction” broke the fever. That should bring back balance.
This summer, Federal Reserve researchers released a paper finding that the Pandemic Housing Boom was driven by a demand surge—not supply constraints.
“Even though the supply of new for-sale listings fell sharply at the beginning of the pandemic, we show that reduction of supply was a minor factor relative to increased demand in explaining the tightening of housing markets over the first year of the pandemic,” wrote the Fed researchers. “Our estimates imply that new construction would have had to increase by roughly 300% to absorb the pandemic-era surge in demand.”
The ongoing housing correction has halted that demand boom. Once mortgage rates moved north of 5%, work-from-home buyers started to second-guess moves to markets like Austin and Boise. Other groups of buyers who helped to drive the Pandemic Housing Boom, like flippers and second-home buyers, also backed off.
The Fed’s inflation fight won’t help to address the nation’s housing deficit. However, by sidelining the Pandemic Housing Boom’s demand surges, the Fed could help to return some “balance” to the market.
4. The housing market correction will soon spread across the economy.
The Fed’s housing reset isn’t just about housing. It’s about taming inflation.
“Housing is a primary transmission mechanism for the Federal Reserve, and its monetary tightening is partially intended to cool the housing market as part of the Fed’s efforts to fight inflation,” said Odeta Kushi, deputy chief economist at First American, a real estate financial services company.
Across the globe, central banks are applying upward pressure on long-term interest rates—including mortgage rates—by signaling that short-term rates will remain higher for longer. As mortgage rates move higher, home sales and homebuilding move lower. That causes demand for services like home loans and moving crews to fail. It also causes demand for commodities (like lumber) and durable goods (like refrigerators) to fail. Those economic contractions then spread throughout the rest of the economy and, in theory, help to weaken the labor market and curtail inflation.
The housing market has already clearly weakened. However, we’re still in the early innings of that weakness spreading through the rest of the economy.
5. The Fed’s mandate isn’t housing.
The Fed has a dual mandate from Congress: Maintain “maximum employment” and “stable prices.” But as long as inflation remains above the Fed’s 2% target, Powell says the latter will be the central bank’s main focus. Even if it means pushing the economy into a recession to achieve it.
Ideally, Powell would like to see the Fed’s housing “reset” return us to a balanced housing market. However, at the end of the day, the Fed’s mandate isn’t to make sure housing is affordable. If inflation proves sticky, one could foresee a scenario where the Fed pushes so hard on the housing market that new construction nosedives. If that occurs, it would likely send us into the type of recession that stamps out inflation. However, it could exacerbate the nation’s housing supply deficit. That would hardly be the type of balance would-be buyers are seeking.
“Since April, we’ve been communicating to clients that the Fed’s intentions were to throw housing demand under the bus, somewhat of a sacrificial lamb to help bring inflation under control,” Palacios tells fortune.