Fed Sees Risk of Big Declines in Still-Lofty US House Prices

(Bloomberg) — The Federal Reserve suggested on Friday that lofty home prices could be susceptible to steep declines after big run-ups in recent years on the back of ultra-low interest rates.

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“With valuations at high levels, house prices could be particularly sensitive to shocks,” the Fed said in its semiannual Financial Stability Report released Friday.

Though housing price increases have slowed recently as the Fed has raised interest rates, valuations remain stretched when compared with such metrics as rents, the central bank said. It also cited “strained” liquidity conditions in the Treasury and some other crucial financial markets; elevated leverage at hedge funds; and high commercial real estate prices when compared with market fundamentals.

Fed Chairman Jerome Powell has taken issue with warnings that the US is on the verge of another economically paralyzing housing bubble bust akin to what it suffered some 15 years ago, arguing that lenders have been much more careful in extending mortgages this time around.

That’s a point also made in the report, which said household debt remains moderate.

But in addition to pointing out that house prices remain elevated, the report said an economic downturn or a correction in real estate prices would put pressure on household balance sheets.

The Fed is in the midst of its most aggressive credit tightening campaign since the 1970s as it struggles to corral an inflation rate that’s near a four-decade high. The S&P 500 rose 1.4% on Friday and is down 21% so far this year.

The rate increases come after years of ultra-easy credit conditions that encouraged borrowers to take on added leverage and prompted investors to adopt riskier positions to boost returns.

“Today’s environment of rapid synchronous global monetary policy tightening, elevated inflation and high uncertainty associated with the pandemic and the war raises the risk that a shock could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage,” Fed Vice Chair Lael Brainard said in a statement accompanying the report.

The Fed also highlighted potential risks to the US financial system from developments abroad, including ongoing stresses in China’s property market and Russia’s invasion of Ukraine. These could affect the US in various ways, including by triggering a general pullback in risk-taking in world financial markets.

The report includes a lengthy discussion on liquidity in financial markets. While saying that the Treasury market has continued to function smoothly, the Fed said liquidity is less resilient than usual. It blamed that mainly on elevated interest-rate volatility stemming from the uncertain economic outlook.

Trading conditions in the nearly $24 trillion Treasury market have at times been difficult after a year of steep losses for bonds, driven by rising inflation, higher Fed interest rates and a reduction in the central bank’s balance sheet.

Some market participants have warned that the loss of liquidity risks a repeat of the sort of money market turmoil seen in September 2019, when the Fed was forced to flood the banking system with cash to prevent the damage from spreading.

(Updates with details starting in fourth paragraph.)