The housing market is one of the most important determinants of the economic outlook. The market serves as the leading indicator of economic performance.
House prices in the US have been falling post-Covid pandemic. The American housing market size had decreased 5 percent from $47.7 trillion in June 2022 to about $45.3 trillion by December 2023. This has been the largest decrease in the US housing market since the financial crisis.
So, how will the fall in house prices affect the overall economy this year? Let’s dive in to find out the impact of the falling US house values on the local economy.
The decline in the housing market is sometimes a warning sign that the general state of the economy is also declining.
Investors often seek safer instruments like mortgages and government bonds when the economy is performing poorly.
As a result, there is a greater demand for house loans that leads to increased long-term mortgage rates. Additionally, it also indirectly leads to an increased interest rate.
In 2022, the Federal Reserve raised interest rates by more than 0.75 percentage points four times.
It’s crucial to remember that the Fed doesn’t have any direct control of mortgage interest rates. It regulates interest rates, but when it raises them, it does so to reduce inflation.
In general, higher interest rates lead to a higher mortgage cost thereby resulting in decreased demand and prices of homes.
Declining home values deter consumer spending and slow economic development. An abrupt decline in home values harms consumer confidence, construction, and the economy as a whole.
A person’s marginal propensity to spend (MPC) as a result of brief changes in income and the value of the property can be used to quantify how consumption responds to changes in home values.
A negative shock to house values would have a significant negative impact on their spending because high-debt, low-net-worth individuals often have high MPCs.
On the other hand, homeowners are better financially and feel more confident when property values increase. Some people will take out extra loans against the house value to finance purchases of goods and services, home improvements, pension supplementation, or debt repayment.
Reduced construction investment from a drop in property prices is expected to result in even more sluggish economic growth. Through what is known as wealth effects, changes in the housing sector, particularly in property prices, can have a wider impact on the economy.
House prices can have a direct impact on economic activity (GDP) in three ways: new house building, modification of existing homes, and housing exchanges. Renovation and new construction have a solid fundamental base and may perform better than anticipated. When all three slow down, it points to a slowdown in the overall GDP of a country.
There are two methods to look at how housing impacts GDP directly.
First, think about the activities related to house sales, such as broker fees, legal costs, etc., which account for a sizeable portion of the GDP footprint of housing.
Additionally, the investment component of net economic spending is impacted by the building of new homes.
Over the previous 10 years, real GDP has been around 4.8% of what has been invested in new residential dwellings on average.
Similar to 2008, sales are currently decreasing from extraordinarily high levels. However, it’s doubtful that financing would suddenly halt, and credit requirements will change significantly as they did in 2008.
The amount of housing that a given payment will purchase has decreased due to rising mortgage rates, but financing is still an option.
Furthermore, household renovation spending is at a 60-year high. This reflects the need for additional home office space in general, not only because of the epidemic but also highlights the stability of household finances, where wealth has increased throughout the income spectrum as a result of reduced transportation expenses brought on by working from home.
This fraction, like the investment category as a whole, often swings more significantly during the economic cycle than overall GDP, hence it varies from period to period.
The second technique to determine the direct impact of housing on GDP is to examine the real residential investment’s percentage-point contributions to real GDP growth.
If investment spending in residential properties increased as expected, real GDP growth would have been about one percentage point higher on average each quarter.
When property prices rise or fall, for instance, families may feel more or less rich and respond by raising or decreasing their spending. Collateral consequences can also have a big impact on consumption. A decrease in house value will result in less access to credit by homeowners.
Since over 70% of American economic activity is made up of consumer spending, even a slight decrease in individual consumption might have a significant negative effect on GDP growth as a whole.
Housing influences the economy beyond actual activity because it is one of the people’s main assets and sometimes their biggest cost.
Household wealth and confidence are significantly impacted when home prices decline. If the decline is significant enough, it may also compel households to fix their damaged balance sheets, which will have a long-term negative impact on investment and consumption. The wealth effect took an extreme form in the 2008 financial crisis, which slowed the decade’s recovery.
Although the susceptibility is not great as it once was, home prices nevertheless have an impact on household financial sheets. Home prices are still low today and are probably going to become even lower, especially considering the recent increase in mortgage rates.
However, it is less probable that they will leave household financial accounts in a worse state than they were before COVID-19. This is due to the remarkable strength of the asset side of family balance sheets as well as the fact that families have significantly reduced their debt over the previous ten years. Therefore, it is unlikely that the overall effects of price declines on the US economy would be as severe as they were in 2007.
Consumer spending and the housing market are tightly related. The quick shift in risk from restricted to systemic in the middle of the 2000s serves as a reminder that housing must be constantly monitored. The intimate connections between housing and economic activity are one risk to be watched.
Consumer spending and confidence will suffer because of declining consumer wealth caused by falling property values in the short term. As a result, the overall level of demand will decline, and producers’ money will flow cyclically with fewer injections. But the long-term prospects remain bright due to the strong consumer confidence and purchasing power of average Americans.