The prospect of a crashing economy is scary. But possibly just as scary—though maybe less dramatic—is the threat of a persistent, dragging crisis, which would result in a much longer period of depressed economic activity, stunting medium-term growth and stability across sectors.
Against the backdrop of the Federal Reserve’s dogged attempt to tame inflation through interest rate hikes and a recent run on regional banks, an analysis by economics firm Oxford Economics explored this possibility, saying that credit scarcity and businesses pulling back on investments could weigh down the economy, with a particular impact on real estate.
“(T)he hallmarks of small, domestically focused institutions facing the twin problems of deposit flight and concerns over asset quality in a rising rate environment suggest the need to take downside risks to the economy very seriously,” wrote Innes McFee, chief global economist for Oxford Economics.
Broadly, economists have been divided about the possibility of a so-called “soft landing,” with some predicting a fast rise in unemployment or entrenched inflation, while others argue it is possible to calm inflation without sinking the broader economy.
Oxford Economics (an independent advisory firm, not affiliated with the prestigious British university) anticipates something of a third option: an ugly downward spiral and a limping recovery. While much less ugly in many ways than the acute crisis of 2008, McFee was clear that the “persistent drag” of a slow-burn economic crunch would be painful and significant. More banks will fail in the next couple years, they said, and businesses will cut back on spending and hiring.
In one scenario, credit tightening would be about one-third of what was seen in 2008, McFee estimated, and roughly equivalent to the “savings and loan” crisis of the 1980s. The worst effects would occur in 2025, and would not level out until around 2027.
Using the high inflation and harsh interest rate hikes of the 1980s as a model, McFee draws many parallels between that crisis (when home prices plunged 12%) and today, with banks back then also failing to strengthen or diversify their balance sheets—a primary cause of bank failures this year.
“This diagnosis could easily be applied to today’s U.S. regional banks simply by substituting mortgage loans for commercial real estate loans,” McFee claimed.
Oxford Economics recently downgraded their forecast for overall GDP growth based on an anticipation of more restrictive credit conditions and a subsequent decrease in consumer spending. A “baseline” scenario would still see more bank failures and more pain in real estate markets.
As far as effects on real estate markets, the firm anticipates more drops in overall prices, but with “limited losses” due to improved underwriting standards. “The ability to resolve failing institutions,” as was the case with the three regional banks that have failed thus far, will “help to limit the impact on the wider economy.”
“This is still the most likely scenario for the economy thanks to the improvements in bank regulation made over the past 15 years,” McFee wrote. “Higher capital and liquidity ratios as well as the ability to resolve failing institutions quickly should help to limit the impact on the wider economy. But uncertainty is high because of patchy bank supervision and the magnitude of the shocks hitting real estate markets.”
A more painful scenario sees real estate prices—particularly in the commercial sector, where recent changes around climate, remote work and ecommerce make valuation difficult—fall more precipitously. This type of recession would still be relatively mild, but could spill into international markets, McFee said.
“In our scenario, the tightening in credit conditions certainly doesn’t help (residential) housing markets, but it’s the weakening in the labor market that drives prices down further. On top of the falls we expect in our baseline, prices in the U.S. slump by a further 10% and by around 7% more in the core European markets,” McFee wrote.
Office and industrial would be hit the hardest due to “softer starting valuations.” McFee said he still anticipates a relatively fast recovery—though other, more ugly possibilities, exist.
Even at the baseline, however, where real estate prices remain resilient and bank failures are isolated, McFee anticipates higher interest rates that remain elevated for longer, and a “prolonged period of tight monetary conditions.” And he admits that predictions around future credit conditions are inherently uncertain, with bank surveys only offering a fuzzy outlook of what could happen.
“(S)urveys only tell us the net percentage of banks tightening lending criteria since the last period, as well as their future expectations,” McFee writes. “They don’t tell us about the absolute level of tightening nor the method they will use, which makes it difficult to get an accurate read of the full impact on the economy.”
