According to a new report from Wells Fargo, the housing correction is in its infancy, and we may see home prices fall 5.5% in 2023. Despite mortgage rates showing signs of easing, it seems notions of a housing market crash may continue for years.

What do you need to know about home prices in 2023?

Well, as the Federal Reserve continues with its hawkish agenda, notions of a Fed-induced recession and accompanying housing market crash continue to grow in prominence and validity. New and existing home sales are falling all over the country. Some regional markets, like Seattle and San Jose, are already experiencing home price corrections.

As per recent housing commentary, Wells Fargo economists Charlie Doughtery and Patrick Barley believe a housing correction is “already well under way,” citing sharp pullbacks in new home sales, builder confidence and single-family home construction. Additionally, the economists believe the low-interest-rate environment that saw many homebuyers jump into the market the past few years will likely take away any incentive for sellers to enter the market. Reasonably so, as 85% of mortgage owners are enjoying lending rates well below current levels, according to Redfin.

Housing is considered one of the most recession-sensitive industries, and as such, it comes as no surprise to many economists to see home prices recede ahead of the greater economy.

However, with a startling number of economists and banks coming out of the woodwork to warn of a housing recession, home prices may be more susceptible than many previously assumed.

The Future of Housing Is in the Fed’s Hands

According to Wells Fargo’s latest analysis, the future of home prices is largely at the whim of greater economic forces. Should the Fed continue raising rates, which seems inevitable given recent inflation reports, housing prices will likely drop even further. Perhaps most startling is the notion that the U.S. is only in the first innings of a potential multi-year housing downturn. This mirrors the country’s slow crawl toward recession.

Wells Fargo expects the U.S. to enter a recession at some point in 2023, with unemployment to peak at 5.4% in Q1 2024. Likely a consequence of Fed interest rate hikes, Wells Fargo expects mortgage rates to remain elevated for the foreseeable future.

“The primary driver behind the housing market correction thus far has been sharply higher mortgage rates … The fiercely hawkish Fed is one reason why we expect mortgage rates to remain above 6% through Q4-2023. As mentioned previously, we expect unemployment to rise and inflation to abate over the course of next year, which should in all likelihood prompt the Fed to reverse course and ease monetary policy by cutting rates. Even then, mortgage rates are likely to remain above 5% throughout 2024.”

Wells Fargo isn’t alone in that assumption, either. A new Bloomberg Economics model projection forecasts a 100% chance of a U.S. recession within the next 12 months. This is a stark contrast from the model’s previous 65% likelihood over the same period. No doubt a consequence of growing expectations of further financial tightening, a recession would only accelerate housing’s downturn.

What Exactly Does a 5.5% Drop in Home Prices Mean?

By some standards, a 5.5% drop in home prices is relatively modest. After all, real estate prices tumbled by nearly 16% in 2008. However, the fragmented nature of the 2022 housing market means some regional markets may experience far more devastating devaluations.

Indeed, over the past two years, some areas experienced unprecedented — and unwarranted — home price growth. Overall, home prices increased a staggering 43% during the pandemic housing boom, largely off the back of rock-bottom lending rates and elevated demand. Some regions saw their home prices climb more than 70%, like Boise, Idaho. Unfortunately, as the chickens come home to roost, these regions may fare more dramatic drops, even if the wider housing market only slumps 5%.

Last month, Moody’s identified 210 regional markets deemed “significantly overvalued,” that is, inflated by more than 25%. Many of these cities have already started experiencing pullbacks, like Austin’s 7.5% drop between May and August, or San Jose’s 10.6% drop. This may well be just the beginning of a far more devastating correction. Wells Fargo echoed this sentiment:

“Keeping that in mind, we now look for home prices to register year-over-year declines in 2023, with the national median existing single-family home price expected to fall 5.5% during the year. We note there is likely to be significant regional variation. Markets where home prices shot the highest are now vulnerable to a disproportionate swing to the downside, notably in previously white-hot markets in the Mountain West which saw an influx of remote workers at the onset of the pandemic.”

Limited Supply Is U.S. Housing Market’s Saving Grace

While predictions of a housing downturn are ominous, there are some important limits to the magnitude of a potential housing crash. First, the inventory of available homes in the U.S. is still quite pinched. As previously mentioned, the current high lending-rate environment will stop many homebuyers from putting their properties up for sale. Rather, they’ll enjoy soaking up low-interest equity on homes purchased during the pandemic.  This will put a damper on the housing selloff as many homeowners in popular areas will likely opt to hold onto their investment if they can.

In that sense, Wells Fargo maintains a relatively sunny long-term view of housing.

“Home prices in desirable locations with comparatively tighter supply are likely to hold up much better. Reduced investor activity in many markets should also weigh on prices. That said, the long-standing shortfall in supply and strong underlying demand will ultimately limit the extent home prices depreciate. Even with a modest correction, prices are likely to remain above the average levels seen in 2021. If our forecast for Fed rate cuts is realized, mortgage rates are likely to fall slightly just as cooling inflation pressures boost real income growth. A modest improvement in sales activity should then follow, which will reignite home price appreciation heading into 2024.”

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.