Falling house prices will help the Fed tame inflation – but they also increase the risk of a prolonged economic downturn

• US home sales are extending declines as Federal Reserve tightening boosts mortgage rates.
• That has helped tame inflation, which is now retreating from four-decade highs.

Housing could be about to become a key policy puzzle for the Federal Reserve.

Market activity has fallen for nine consecutive months and home sales were down 28.4% in October from a year earlier, according to the National Association of Realtors, with some economists warning that prices could plummet 20% next year as the broader slowdown kicks in.

While house prices will need to see some softening so that headline Consumer Price Index inflation can be reined in, a dramatic real-estate crash could also have a knock-on effect on the economy as a whole. And that would cause a fresh policy headache for the Fed, which has raised interest rates six times this year to combat price pressures.

Here's how the Fed's monetary-tightening campaign has affected the housing market – and why the sector could play a key role in determining whether Chair Jerome Powell can successfully bring down soaring prices without triggering a recession.

Why are home sales falling?

The Fed has boosted borrowing costs by 75 basis points at each of its last four consecutive meetings to fight inflation.

The aggressive monetary tightening lifted the average 30-year US mortgage rate from 5.60% to 6.84% over the last three months, according to Bankrate.

Rising mortgage rates tend to deter potential home buyers because they make housing loans more expensive.

"A decline in home buying is one of the byproducts of tighter monetary policy," Macquarie's head of economics David Doyle told Insider. "Housing is an interest-rate sensitive sector so it is no surprise that it has slowed materially in the current context."

What has the Fed said about the housing market?

So far, the Fed has shrugged off any talk that its rate hikes have negatively affected housing.

Powell said last month that the market would "have to go through a correction" after a combination of pandemic-era fiscal stimulus and tight supply fueled a housing bubble last year.

Still, some central bank economists have called for the Fed to pay more attention to home sales and prices as they start to slow significantly.

"Monetary policy needs to carefully thread the needle of bringing inflation down without setting off a downward house-price spiral - a significant housing selloff - that could aggravate an economic downturn," the Dallas Fed's Enrique Martínez-García said last week.

How do falling house prices help the Fed?

The Fed's main priority right now is taming inflation, which is still running way above its 2% target.

Home prices saw the biggest increase in 34 years of 18.8% last year, according to the S&P CoreLogic Case-Shiller US National Home Price Index – and so the central bank likely sees taking some froth out of the market as a means of bringing inflation under control.

But October's 7.7% CPI print suggested that inflation is now starting to decelerate, which could give the Fed the necessary scope to start tempering its hawkish stance on interest rates.

"As mentioned previously, we expect unemployment to rise and inflation to abate over the course of next year, which should in all likelihood prompt the Fed to reverse course and ease monetary policy by cutting rates," Wells Fargo economists Charlie Dougherty and Patrick Barley said in a recent research note.

Could the slowdown cause a recession?

But the central bank will need to nail the timing of such a policy pivot – because over tightening could drive down housing market activity and accelerate a potential recession next year.

That's because housing has a multiplier effect on the economy, generating income for estate agents, decorators, and other industries involved in the sales process.

Should borrowing costs remain too high for too long, those industries risk facing a decline in business at a time when monetary tightening is already squeezing their cash flows.

"Eventually this should spill over and begin to impact jobs growth and the labor market," Macquarie's Doyle told Insider. "This is partly why we anticipate a recession in 2023."