Recession fears are escalating as the economy is slammed by higher energy prices and tighter monetary policy. While higher interest rates are intended to slow things down, this may be working too well in the housing sector, where the pandemic boom is coming to a screeching halt. Is a housing bust going to tip the slowing economy over the edge? And could that recession have lasting structural consequences?
Downplaying the role and risk of housing in the economy is treacherous. In 2007, Ben Bernanke, then chair of the Federal Reserve, said that troubles in housing “will likely be limited,” and at the time that may have been true. But the rapid transformation from limited to systemic risk in the mid-2000s reminds us that housing must be continually watched. Is it merely a headwind, a credible recession driver, or—worse—a structural risk?
Watching those risks includes keeping an eye on housing’s direct linkages to economic activity, its indirect impact on household finances, and its indirect linkages to the banking system. There are varying degrees of stress in all of these. Yet while the housing slowdown adds to a confluence of headwinds that could easily tip the economy into recession, a bigger fallout from the sector remains unlikely.
Housing activity could be more robust than you think
Housing has three direct linkages to economic activity (GDP): the construction of new homes, the remodeling of existing homes, and that of housing transactions. Though all three will decelerate and thus be a headwind to the cycle, remodeling and new builds have a strong fundamental backdrop and may turn out more robust than expected.
First, consider the activity associated with home sales—think broker fees, lawyers, etc.—which are a sizable contributor to housing’s GDP footprint. Today, as in 2008, sales are declining from exceptionally strong levels. But the sudden stop in financing and sustained shift in credit standards that undermined housing transactions in 2008 is unlikely this time. Mortgage rates have shot up, shrinking how much house the same payment will buy, but financing remains available.
Next, spending on residential remodeling is running at a 60-year high. This speaks not only to the pandemic-induced need for more home office space. It also speaks to households’ strong balance sheets, where wealth has grown across the income distribution with pandemic stimulus and the inability to spend freely. Though household wealth is coming under pressure—just think about the drawdown in equity markets—balance sheets are unlikely to be structurally impaired this time around.
Third, in a critical difference to the mid-2000s, there just isn’t enough housing supply today. Today’s low housing inventories are consistent with continued building activity even against a backdrop of higher rates, because the risk of being unable to sell homes when there are few on the market is lower.
Housing’s impact on household finances looks mixed
Beyond real activity, housing also impacts the economy because it is one of households’ largest assets and often their largest expense. When house values fall, that has a material impact on household wealth and confidence – and if the drop is big enough, it forces households to repair their damaged balance sheets, weighing down investment and consumption for a sustained period. The crisis of 2008 was an extreme version of this wealth effect and contributed to the sluggish recovery of the 2010s.
Today home prices remain elevated, and they are likely to weaken, particularly given the surge in prices during the boom and the recent surge in mortgage rates. But the prospects that they leave household balance sheets in a weak position relative to where they were before COVID-19 is less likely. This is because of the remarkably strong asset side of household balance sheets and because households have deleveraged substantially over the past decade. Home prices still matter for households’ balance sheets, but the vulnerability is not the same today.
Though balance sheets are quite likely resilient to housing stress, two additional household linkages are more negative. First, refinancing: When interest rates fell during the pandemic households were able to refinance, lowering their interest cost and freeing up income to spend elsewhere. Second, when rents and other housing costs increase that means there is less income to spend elsewhere.
Today, each of these are headwinds to the economy. Substantially higher mortgage rates mean that refinancing activity will be modest going forward, so very few households will gain extra discretionary income for spending. And very tight housing inventories, a strong recovery, and surging home prices and rents have all helped to deliver the fastest growth in housing costs in decades—eating into discretionary income.
The banks are alright
In one area of the economy housing linkages run in two directions – that of the banking sector. Housing is particularly affected by the flow of credit from the banking system (and shadow banking system), and banks are particularly affected by the health of housing. In 2008 extraordinarily easy credit was extended to over-leveraged households by banks that were undercapitalized and over-leveraged themselves.
When housing began to weaken and credit losses started a pernicious spiral of weaker housing leading to weaker banks, leading to tighter credit, leading to weaker housing, the economy quickly found itself in a systemic crisis. This threatened to deliver a depression, but adroit—if too slow—policy action to break the downward spiral helped stabilize the economy and a U-shape recovery took hold.
Today, credit quality, access, and financing costs look different. Unlike 2008, defaults are low, non-performing loans are rare and the banking system is in robust health with high levels of capital and profits. This has helped keep credit accessible, after a brief tightening at the beginning of the COVID crisis, for the same type of borrowers that had access before COVID struck—even if that credit is now more expensive.
Recession, or worse?
Today it is true that many of housing’s economic linkages are under significant pressure – a level of pressure that is not likely to abate as rates may stay higher than they have been in many years. And this pressure further raises the risk of a recession in coming quarters as housing sales slump, refinancing stops, and builders feel pinched.
Yet when looking at the different linkages the argument for sustained weakness or systemic threat seems much weaker than in the last cycle of housing boom and bust. Household’s balance sheets are extremely strong, and housing leverage is modest; credit standards have been healthy and there are few signs of credit stress; and banks are profitable and strongly capitalized. Even builders who feel the pinch of higher rates are likely to continue to build at a strong (if not as strong) clip as housing inventories are very low, a strong fundamental backdrop to building which won’t meaningfully change quickly.
Though housing is a significant headwind, when considering recession risk the key question should be what type of recession could it be, more than a binary question of whether a recession will come or not. And here the distinctions about the nature of housing risks are crucial. The good news is that the risks that emanate from housing today are more about compounding other headwinds and not about a dramatic financial recession. Don’t expect housing to drive the lasting structural economic consequences we saw the last time the market went bust.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
Sign up for the Fortune Features email list so you don’t miss our biggest features, exclusive interviews, and investigations.