Is the Fed Trying to Induce a Recession?

Is the Fed Trying to Induce a Recession?

At the end of July, the Federal Reserve raised interest rates by another 0.75 points in an ongoing attempt to cool inflation in the slowing U.S. economy. The Fed indicated more increases are coming in a post-meeting statement. The central bank has raised rates by a quarter point, a half point, and three-quarters of a point in March, May, and June respectively. The latest increase is the second “supersize increase” in 2022 and has not been matched prior to 2022 since 1994.

When the Fed raises rates, the move first affects mortgage rates and pushes them upward as well. Historically, higher interest rates have caused demand for housing to decline and existing home inventory to spike. As new-construction builders cut back on production, the demand for materials like lumber and goods such as windows and appliances falls and the cost of those good falls as well. Although housing is not necessarily the target of the rate increases, the result is that housing gets hit first.

“The most frequent way we enter into recession is the Fed raises rates to fight inflation,” explained economist Bill McBride. “Housing is not the target, but it is essentially the target.”

Even before the latest rate hike, housing was contracting this year. Year-over-year, mortgage applications are down nearly 20 percent and new construction sales are down more than 17 percent. However, unlike other times when the Fed has raised rates, in the post-pandemic economy homebuilding and home sales are not reacting the way they traditionally have.

Because of severe supply constraints and high demand for housing, there are still a record number of homes under construction. McBride said he believes this could “prevent the spike in construction job cuts that normally come before a Fed-induced recession,” especially since many of those properties are already sold.

However, said Rick Palacios Jr., head of research at John Burns Real Estate Consulting, the end result could be both a dip in home prices and a Fed-induced recession. Palacios said the rise in home prices in many hot markets has been “purely aspirational and irrational,” which means that about 10 percent of the increase will likely “come off the top really fast.” This essentially will mean that the housing cycle “turns over” before inflation stops, which could mean more and more rate increases as the Fed struggles to halt inflation but fails to affect housing enough to do so.

For real estate investors, the key in the next few years will be to remain creative and flexible as the market changes. While so many things are changing, it will be important to remember that many elements of the economy are not behaving in historical fashion. As Palacios put it, you cannot “allow the psychology of inflation to get out in front of you.”