Fortune

BY LANCE LAMBERT

In the early ’80s, homebuilders mailed two-by-fours to then Fed Chair Paul Volcker in hope the central bank would relax its inflation fight that saw mortgage rates top 18%. Of course, the Fed didn’t back off until the 1981 recession helped tame the inflationary spike that began a decade earlier.

Historically speaking, the Federal Reserve’s inflation fighting playbook always starts with housing. It goes like this. The central bank begins by applying upward pressure on mortgage rates. Not long afterwards, home sales sink and existing home inventory spikes. Then homebuilders begin to cut back. That causes demand for both commodities (like lumber and steel) and durable goods (like windows and refrigerators) to fall. Those economic contractions then quickly spread throughout the rest of the economy and, in theory, help to rein in runaway inflation.

“The most frequent way we enter into recession is the Fed raises rates to fight inflation. The leading indicator for this type of recession is housing,” Bill McBride, author of the economics blog Calculated Risk, tells Fortune. “It [housing] is not the target, but it [housing] is essentially the target.”

Of course, this chain of events has already started.

Mortgage rates, which have jumped from an average 30-year fixed rate of 3.1% to 5.54% this year, have already pushed the U.S. housing market into a sharp slowdown. Some economists are calling it a “housing correction” while others label it a “housing recession.” Regardless of the label, it’s clear housing activity is contracting: On a year-over-year basis, mortgage applications are down 19%.

While a housing recession is good news for the inflation fight, it also means a National Bureau of Economic Research declared recession could be drawing closer. McBride doesn’t think we’re in recession now, however, he says a Fed-induced recession is a real possibility. The slowing housing market, he says, tells us so.

One thing stands in the way: Homebuilding. On a year-over-year basis sales of new single-family homes is down 17.4% while single-family housing starts are down 15.7%. That said, homebuilders remain busy. A combination of supply chain constraints and an eagerness to cash in on the pandemic housing boom led homebuilders to ramp up production massively over the past year. In fact, there’s currently a record number of U.S. homes under construction. As long as builders and contractors remain busy, McBride says that’ll prevent the spike in construction job cuts that normally come before a Fed-induced recession.

Not only are there a record number of U.S. homes under construction, there are a record number of unsold homes under construction too. As those unsold homes hit the market, that’ll put more cold water on the housing market. Rick Palacios Jr., head of research at John Burns Real Estate Consulting, tells Fortune that supply could push house prices lower in bubbly markets across the country.

“You could make a strong case that in a lot of housing markets the last 10% of home price appreciation was purely aspirational and irrational, and that’ll come off the top really fast,” Palacios says. “That’s exactly what we’re all seeing right now.”

John Burns Real Estate Consulting predicts that we’re headed for both a dip in U.S. house prices and a Fed-induced recession. The reason? The housing cycle has already “turned over,” and the failures of the 1970s have taught the Fed to not relent until inflation is slayed.

“The lesson learned in reading [Paul] Volcker’s piece, that’s where they messed up. If you have this red-light-green-light mentality around inflation, then you’re going to allow the psychology of inflation to get out in front of you,” Palacios says.

The silver lining, Palacios says, is that supply chain constraints and labor shortages prevented an even greater ramp up in homebuilding. If that would’ve happened, we might have gotten a housing bust—instead of just a housing correction.

“Builders lucked out in that they couldn’t add as much supply as they wanted to in real-time. Because if they would have done that, we would’ve oversupplied the hell out of the market. We would be in a much different backdrop right now. While the supply chain stuff was such a nightmare and made it hard, it put a governor on something that now we’re probably glad as an industry happened,” Palacios says.

In 2007, economist Edward Leamer published the now infamous research paper “Housing Is the Business Cycle.” The paper calculated that in the post–World War II era, eight recessions out of 10 came after a “substantial” housing slowdown. Since then, we’ve had two more recessions: the Great Recession starting in 2007—which was set off by a bursting housing bubble—and the COVID-19 recession, which did not come after a housing contraction. So by the latest count, a housing slowdown has preceded nine out of the past 12 recessions.

But those exceptions weren’t Fed-induced recessions. Amid Fed-induced recessions, like in 1981, the housing recession started long before broader layoffs or before the actual recession hits. Simply put: If we are indeed barreling towards a recession, it could still be some time before unemployment begins to surge.

Moody’s Analytics chief economist Mark Zandi agrees that Fed-induced recessions appear through contractions that begin in the part of the economy that is sensitive to interest rates. But really, Zandi says, it’s housing that does it. Heading forward, he projects a 55% chance of a recession over the next 12 months. Without a recession, he predicts U.S. house prices will remain flat while significantly “overvalued” housing markets, like Boise and Phoenix, could see house prices fall 5% to 10%. If a recession hits, Zandi predicts significantly house prices in “overvalued” markets could fall 15% to 20% and nationally prices could fall 5%.

So why is Zandi reluctant to predict a national year-over-year decline in house prices? It boils down to the fact that home prices are sticky because home sellers dislike giving up any gains. Even during most recessions, U.S. house prices rise.

That said, this time could be different. The pandemic housing boom—during which U.S. house prices spiked 42% over the past two years—detached from fundamentals. Historically speaking, this marks the third occasion over the past half century that U.S. home prices have become “significantly” detached from underlying economic data. It also happened during the housing booms of the ’70s and ’00s.

While those previous two housing booms each resulted in a period of falling home prices, they really were dissimilar. The ’00s housing bubble, of course, ultimately led to falling home prices for multiple years that still haunts the real estate industry. Meanwhile, the ’70s boom—which also occurred during an inflation boom—only resulted in a very brief drop in home prices.

Throughout the ’70s developers built as many homes as they could muster, but it wasn’t enough. By the end of that decade, the supply and demand mismatch had sent U.S. home prices up a staggering 167%. That period, of course, saw something we’re seeing once again today: a wave of inflation. By the early ’80s, the Federal Reserve had tamed the inflation beast through higher interest rates. Those spiked mortgage rates—which peaked at 18% in 1981—pushed the housing market into a brief year-over-year nominal price decline in 1982. However, it wasn’t a housing crash. Instead, housing was able to return to a balanced market by the mid-1980s following several years of strong income growth.

Based on past history, McBride says, it’s likely we’ll soon see something similar to what occurred during the early 80s. On a nominal basis, he predicts U.S. house prices will be flat over the coming year. In the subsequent years, he expects a period of “stalled” nominal house price growth and falling “real” house prices (i.e. inflation growth minus nominal house price growth). If that occurs, McBride says, we’d see “the fundamentals” return closer to historic norms.

What does that mean for buyers and sellers? McBride predicts it’ll be a much friendlier environment for home shoppers.

“I do think we get back to people having open houses and no one showing up,” McBride says.

Lance Lambert is the editorial director of Fortune Education. He also writes the weekly Fortune Analytics newsletter and reports on topics ranging from the future of work to the housing market.