Fed sees risk of big declines in still-high US home prices

(Bloomberg) — The Federal Reserve suggested on Friday that high home prices may be susceptible to a sharp decline after big jumps in recent years amid ultra-low interest rates.

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“At high levels of valuations, house prices can be particularly sensitive to shocks,” the Fed said in its semi-annual financial stability report released on Friday.

Although home price gains have slowed recently as the Fed raised interest rates, valuations remain stretched compared to such metrics as rents, the central bank said. It also cited “strained” liquidity conditions in the Treasury and some other important financial markets; increased leverage in hedge funds; and high commercial real estate prices relative to market fundamentals.

Federal Reserve Chairman Jerome Powell has pushed back against warnings that the U.S. is on the brink of another economically crippling housing bubble burst similar to the one it suffered about 15 years ago, arguing that lenders have been much more cautious in extending the mortgages this time.

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

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

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

The rate hikes come after years of ultra-loose credit conditions that encouraged borrowers to take on extra leverage and prompted investors to take riskier positions to boost returns.

“Today’s environment of rapid synchronous tightening of global monetary policy, increased inflation and high uncertainty related to the pandemic and war raises the risk that the shock will lead to an increase in vulnerabilities, for example due to tight liquidity in the main financial markets or hidden leverage,” said Deputy Fed Chairman Lael Brainard said in a statement accompanying the report.

The Federal Reserve also highlighted potential risks to the US financial system from events abroad, including continued stress in China’s housing market and Russia’s invasion of Ukraine. They could affect the US in a variety of ways, including triggering a general retreat in risk-taking in global financial markets.

The report includes a lengthy discussion of liquidity in financial markets. While it said the government bond market continued to function smoothly, the Fed said liquidity was less resilient than usual. He blamed this mainly on increased interest rate volatility stemming from the uncertain economic outlook.

Trading conditions in the nearly $24 trillion Treasuries market were tough at times after a year of big losses for bonds driven by rising inflation, higher Fed interest rates and shrinking central bank balance sheets.

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

(Updates with details starting in the fourth paragraph.)

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