What Effect Would Falling House Prices Have on U.S. Economy?

ST. LOUIS — Some economic analysts have predicted that a sharp decline in U.S. housing prices could dramatically slow consumer spending, thus leading to a recession. The likelihood and overall impact of sharply lower home prices in many markets, however, is uncertain, based on an analysis by an economist with the Federal Reserve Bank of St. Louis.

St. Louis Fed economist David C. Wheelock looked at the history and effects of falling house prices for the April issue of The Regional Economist, a quarterly publication of business and economic topics published by the Reserve Bank. The publication is also available online at the St. Louis Fed's web site: http://www.stlouisfed.org.

Between 2001 and 2005, U.S. homeowners enjoyed an average increase of more than 54 percent in the value of their houses, as measured by the Office of Federal Housing Enterprise Oversight. The actual number, of course, was dictated by the old saw about the three primary determinants of any piece of real estate: location, location, location. For example, on the high end, houses in the Port St. Lucie-Fort Pierce, Fla., area rose by an average of 144 percent. On the other end of the scale, homes in Lafayette, Ind., rose on average by only 11 percent.

"Historically," said Wheelock, "differences in income and population growth largely explain why house prices rise at different rates in different markets."

At the same time, many commentators have argued that "speculative bubbles" arose in housing markets throughout the country, leading to overly high prices. Wheelock said that several factors were in play that argue against bubbles, however, including unusually low mortgage rates during the early part of the decade and, in some markets, a limited quantity of available land for the construction of new homes.

Nevertheless, many economic analysts have been predicting a collapse of housing prices for some time and, in the past, some house price booms were followed by large price declines. "However," said Wheelock, "other booms simply fizzled out into extended periods of flat or slowly rising house prices."

Analyzing those historical periods, Wheelock noted that in the 1980s and '90s, for example, there were 20 state-level housing booms, defined as three or more quarters of annualized growth in excess of 17 percent in the ratio of house prices to state per capita income. Of those booms, 10 were followed by declines in nominal house prices of at least 5 percent while nine were followed by declines of more than 10 percent over of period of four or more quarters.

"The other 10 booms were followed by extended periods of either flat or slowly rising prices," said Wheelock, "indicating the adage 'what goes up, must come down' does not always apply to housing markets."

At the same time, Wheelock said that several instances of large declines in house prices were not preceded by a boom.

A key aspect of the debate about the impact of the recent housing boom consumer spending has been the use of funds that homeowners obtain from refinancing their mortgages or from home-equity lines of credit. During the boom, for example, homeowners extracted more than $1 trillion of equity from their homes. Although what they spent the money on isn't completely known, some analysts estimate that as much as 60 percent of that extracted equity was used for consumption, while other studies conclude that it may have been invested or used to pay down debt. If the former is true, then a decline in housing wealth could seriously erode consumer spending. If the latter is more accurate, however, that would suggest that a modest fall in house prices would not lead to a sharp pullback in spending.

Of course, a serious decline in housing prices could send ripples through the economy, particularly on lending institutions. Wheelock said that, fortunately, compared to the condition of banks around 1990, U.S. banks today are much better capitalized and better able to withstand a modest increase in defaults on real estate loans.

He also emphasized that "banking supervisors are keeping an eye on the exposure of banks to real estate, as well as their overall safety and soundness, to try to minimize the damage that would result from any collapse in real estate prices."

While acknowledging that falling housing prices in many markets would probably cause an increase in mortgage loan defaults, as well as distress for people engaged in housing construction and other real estate-related employment, Wheelock said that the "extent to which a decline in housing prices would affect consumer spending is uncertain." He also concluded that policymakers such as the Federal Reserve "will continue to watch closely for signs that a housing slump is having a broader impact on the economy."

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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