In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi share their outlook for 2023, outlining three potential scenarios for the housing market in the year ahead.

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Listen to the REconomy Podcast™ Episode 53:

“Once mortgage rates have peaked, the housing market will likely stabilize. Once adjusted to the new normal of higher rates, the housing market will benefit from continued strong demographic-driven demand relative to an overall long-run shortage of supply. So, based on current dynamics, it appears the housing market may be poised to begin to stabilize in 2023.” – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 53 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, can you believe it's already December?

Mark Fleming - Hi, Odeta. I just don't know, where did this year go? It flew by. It seems like just yesterday we were talking about the spring home-buying season. And here we are approaching the holiday season.

Odeta Kushi - And you know what that means?

Mark Fleming - Of course, it's holiday shopping time.

Odeta Kushi - Well, yeah, that too, but not too much holiday shopping.

Mark Fleming - Okay, I have to do this. Maybe Christmas doesn't come from a store. Maybe Christmas, perhaps, means a little bit more. See our REconomy playlist on Spotify for more.

Odeta Kushi - My favorite holiday movie, by the way. So good reference there. I think that might be Fed Chair Powell's holiday wish -less spending, less inflation. But what I actually meant is that it's time for our 2023 housing market outlook.

Mark Fleming - Ah, yes, as opposed to the Grinch, that certainly makes more sense. 2023 is going to be a really tough year to forecast, assuming we can't ask the Ghost of Christmas Yet To Come.

Odeta Kushi - Oh my goodness, okay. Forecasting is fraught with folly. Get it? Folly, holly?

Mark Fleming - Rhymes with Holly. Okay, okay.

Odeta Kushi - We're on a roll here. Maybe we should stop while we're ahead. All right, before I get to the 2023 outlook, I'm going to quote a short excerpt from a Harvard Business Review article that I think summarizes forecasting well. Quote, the primary goal of forecasting is to identify the full range of possibilities, not a limited set of illusory certainties. Whether a specific forecast actually turns out to be accurate is only part of the picture. Even a broken clock is right twice a day. Above all, the forecaster's task is to map uncertainty. For in a world where actions in the present influence the future, uncertainty is opportunity. End quote.

Mark Fleming - I have to add to this because our one of our colleagues, Colin, recently pointed this one out to me. In the illustrious words of John Maynard Keynes, "In the long run, we are all dead. Economists set themselves too easy, too useless a task. If in the tempestuous seasons," -- I guess we're in one right now -- "they can only tell us that when the storm is long past the ocean will be flat." So this is our way of saying that we're not going to give you any specific numbers for our housing outlook for next year.

Odeta Kushi - That was a really long-winded way of us telling that message. So what we will do is walk through three different scenarios, a base case, an upside case, and a downside case, that are all anchored to the Fed's monetary tightening decisions, which is, of course, based on the path of inflation. So let's start with the base case.

Mark Fleming - Inflation, inflation inflation, it will be the theme. The base case is a terminal rate for the fed funds rate, which is the level at which the Fed is expected to stop raising interest rates. And this is something that they telegraphed themselves, somewhere between five and five and a quarter percent by the middle of next year, which unfortunately does imply more rate hikes.

Odeta Kushi - And that also means there may be continued upward pressure on mortgage rates. We know that the popular 30-year, fixed mortgage rate is loosely benchmarked to the 10-year Treasury bond and inflation expectations remain high. That means more upward pressure on Treasury bonds and, therefore, mortgage rates.

Mark Fleming - So rates have already hit 7% and bounced around that level for the last month or so. Are you suggesting that the base case could take mortgage rates even higher?

Odeta Kushi - It's certainly possible. I don't think 8% mortgage rates are out of the question for the base case. But what would that imply for the housing market?

Mark Fleming - Well, lower sales and further annualized price deceleration. Existing-home sales are currently sitting around 4.43, to be exact, million seasonally adjusted annual rates of sales. But rates at 7% or above implies sales trending lower, closer toward 4 million. That's because higher rates have the dual impact of pricing out buyers, and very importantly, keeping sellers on the sidelines and rate locked-in.

Odeta Kushi - And when it comes to house prices, further, broad-based annualized price deceleration. And by broad-based, I mean across all major markets, but particularly in markets that experienced some of the fastest acceleration over the pandemic.

Mark Fleming - But there is also a light at the end of this tunnel in our base case. Once the Fed hits the terminal rate, that will be an indication that we have a handle on inflation. They're stopping there because they see inflation really beginning to fade away. And there's good reason to believe that goods inflation, which was due largely to COVID-related supply disruptions in combination with a COVID-related demand surge for goods relative to services, is what originally drove the surge in overall inflation in 2021. That has moderated in recent months and is likely to slow even further.

Odeta Kushi - And, as we mentioned time and time again, we know that shelter inflation lags observed rental and house price increases in both the CPI and the PCE indices by up to 12 months. So the deceleration we're seeing in house price growth and rental appreciation will start to show up next year and put downward pressure on overall inflation.

Mark Fleming - So, now the big question then is, what happens to wages, and particularly wages in the service sector?

Odeta Kushi - Right, the services sector consists of over 131 million workers, making up 86% of total non-farm employment. So, to slow services inflation, wage growth needs to slow in the sector. But, because of the tight feedback loop in the service sector - employees demanding higher wages to keep up with rising prices and then those wage increases translate into higher prices for the services provided. Elevated service-sector inflation could develop into a wage-price spiral. That is what the Fed is afraid of.

Mark Fleming - Yes, the dreaded wage-price spiral, but we are seeing some slowing in the labor market. And, as consumers continue to spend down their excess savings, it's likely that they'll pull back on services spending as well. So there is a case to be made for slowing services inflation next year as well, maybe in the second half of the year.

Odeta Kushi - And once we're on the other side of rate hikes, mortgage rates should stabilize, while prices adjust down to give buyers a bit of a buying power boost. That should bring some buyers off the sidelines.

Mark Fleming - And know that our base case does not assume a recession in 2023. That's not because it's been ruled out as a possibility next year, but just not to overcomplicate this particular scenario.

Odeta Kushi - Well, speaking of a recession, let's move on to a downside scenario.

Mark Fleming - Yes, I think it should be clear by this point that a downside scenario is somehow related to the stubbornness of inflation, or that inflation gets even worse. And that means that the Fed would continue to raise rates beyond that terminal rate that we were talking about earlier, or faster than anticipated now, and basically put more pressure in terms of monetary tightness in the market.

Odeta Kushi - And that would put even more upward pressure on mortgage rates and even raises the possibility, or probability, of a recession.

Mark Fleming - And not rocket science here. Mortgage rates that go beyond 8% could further freeze the housing market, prompting sellers to stay put more so than the base case due to the rate lock-in effect and buyers being further priced out of the market. That's basically the scenario, stubborn inflation, higher mortgage rates, more of what we've seen this year.

Odeta Kushi - And we will see further price declines from the peak and more markets experiencing price declines.

Mark Fleming - Right. And not to mention the impact that accelerating inflation would have on consumer spending power and confidence.

Odeta Kushi - Well, consumers dictate the path of our US economy. Consumer spending makes up 70% of economic growth. So a more aggressive Fed really does increase the risk of a recession.

Mark Fleming - And I feel like, okay, bah humbug, right here. We can't forget the impact on homebuilding. Home builders are already halting production on new homes as buyer traffic has decreased significantly and higher material and financing costs have made it more expensive to build.

Odeta Kushi - Higher than anticipated inflation, resulting in a more aggressive Fed means builders would really hit the brakes on building new home homes. Bah humbug indeed.

Mark Fleming - All right, let's move on from the downside case, because it is the holiday season after all.

Odeta Kushi - Yes, it is best to end with the upside scenario. Best for last, indeed. Well, I'm sure you can guess that if the base case is a terminal rate of five to five and a quarter percent, the downside case is beyond five and a quarter, than the upside case is that we don't even get to this 5% terminal rate because inflation comes down faster than expected. But how realistic is this?

Mark Fleming - Let's just say, the probability is not zero.

Odeta Kushi - Message received. The economist's way of saying not very likely.

Mark Fleming - Yes. Well, we talked about the shelter component of inflation, which makes up a third of the overall total of the Consumer Price Index. We're not likely to see the impact of that deceleration on shelter inflation until well into next year. And we need to be clear here. The Fed knows this too, because they wrote a paper on it. Literally on it. So services inflation is likely to remain stubbornly high and consumers are still sitting on excess savings they can spend into next year. You get the point.

Odeta Kushi - On that savings point, a recent estimate from Wells Fargo indicates that households still have just over a trillion dollars in accumulated savings through October of this year. That translates to less than a year's worth of excess capital remaining. It would take households another 11 months to completely deplete this stockpile, if they can trade continue to draw down at the $97 billion average pace that they have over the past six months. So, spending could remain more elevated than the Fed would prefer for some time. But, to your point, it's likely that the Fed will have to get to that 5% case. That's understood. But let's play out this upside scenario. Say inflation does surprise to the downside.

Mark Fleming - Okay, so we grant Chair Powell his holiday wish, and consumers choose to pull back on spending, not spending that $97 billion of excess savings a month, then mortgage rates may stabilize sooner than in the base case. And potential buyers and sellers would benefit from the lack of rate volatility. All that certainty certainly helps. And prices would continue to adjust down to the new reality of higher mortgage rates, basically giving an affordability boost to potential home buyers as prices come down.

Odeta Kushi - But, unfortunately, even in this scenario, the housing market will still struggle from a lack of supply. Potential sellers would still be locked into record-low mortgage rates and hesitant to sell in a higher interest-rate environment.

Mark Fleming - That's a good point. Even if buyers benefit from the upside scenario, potential sellers may still stay put. And, as we've said before, you can't buy what's not for sale, even if you can afford it again.

Odeta Kushi - So for the housing market, in all three cases, we expect ongoing rebalancing as prices adjust to the reality of higher rates. But the pace of price deceleration and the decline in home sales will be more severe in the downside, higher inflation scenario.

Mark Fleming - I'm just laughing I feel like the the old Econ joke - on the one hand, and on the other. But, in this case, and on the third hand. And so in all three scenarios, we don't expect a housing bust similar to the mid-2000s, as lending standards in the housing cycle have been much tighter and there likely won't be a surge in distress sales. So that's the good news under all three 'hand' scenarios.

Odeta Kushi - A one-handed economist, right? That's what everyone wants.

Mark Fleming - We are three-handed economists

Odeta Kushi - Yeah. And, of course, all of these scenarios do not consider any potential additional economic or geopolitical shocks. Ultimately, the housing market trend to watch in 2023 is whether mortgage rates will go any higher and, if so, by how much. Once mortgage rates have peaked, the housing market will likely stabilize. Once adjusted to the new normal of higher rates, the housing market will benefit from continued strong demographic-driven demand relative to an overall long-run shortage of supply. So, based on current dynamics, it appears the housing market may be poised to begin to stabilize in 2023. So we'll end on that more positive note. That's it for today. Thank you so much for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.