Deflation and Fed’s Lack of Urgency Are Putting Durable Goods at Risk

The Fed left interest rates and overall monetary policy unchanged today. We have now had six straight meetings with no change in rate policy. The Fed remains focused on a 2% target. Still, they appear to recognize that waiting could lead to even more economic slowing, which is ultimately the goal, with better balance of employment and inflation.

We do not have new rate projections, but in March, their “dot plots” suggested three quarter point cuts by the end of the year. The financial markets are now expecting, at most, one rate cut at the end of the year. Fed officials are likely fine with that current perspective, but if we wait that long, the durable goods sector is likely to begin experiencing even more pain.

According to the GDP data, the durable goods sector is seeing deflation and is already in a recession. Keeping monetary conditions restrictive risks making it worse and, potentially, spilling over into other areas of the economy.

Real GDP growth was 1.6% in Q1. Durable goods declined 1.2%. We are no longer in 2023, when pent-up demand, excess pandemic savings and revenge spending kept the economy growing despite the Fed’s aggressive tightening. We have been on cruise control in restrictive territory for nine months.

A clear signal that the Fed understands that relief needs to come eventually was apparent in today’s policy decision on tapering of quantitative tightening (QT), which is the ongoing selloff of their balance sheet. Slowing the balance sheet runoff will reduce the pressure on longer-term rates moving even higher.

Bond yields have, in fact, moved higher this year and were little changed today with the policy announcement. Hopefully, we have seen the peak.

All types of consumer rates have moved higher in 2024. The average new auto loan interest rate remains at 9.7%, up over 80 basis points (BPs) year over year. The average new rate peaked just below 10% in October 2023 when the 10-year and mortgage rates also peaked. The average used auto loan rate peaked in February this year at 14.6% and is currently off its peak at 14.1% but up 60 BPs year over year and up 3.7 percentage points compared to May 2019.

Most buyers finance durable goods like autos. As a result, the monthly payment is the metric that tests affordability. Even though prices for vehicles, both new and used, have been slowly falling, the declines are not producing much relief in monthly payments because interest rates have risen.

The story of 2023 was the resilient economy that avoided recession despite aggressive tightening by the Fed. But that was last year’s news. It’s different now. Durable goods are the canary in the U.S. economy, and that canary has already run out of oxygen.

The exact level of inflation that is ideal or tolerable is debatable. The Fed is focused on 2%, but many would suggest that 2.5% or even 3% would also be fine for the economy. And we are already in that range.

However, deflation is potentially even scarier, and the durable goods sector has officially dealt with deflation for the last three quarters. Both new and used vehicle prices have been declining for two years. Initially, this was a correction and return to normalcy, but the market is at an inflection point because consumers now expect that prices will keep falling. Economists call this a deflationary spiral.

A deflationary spiral occurs when consumers delay purchases with expectations of lower prices, which reduces demand, builds up supply, and leads to the lower prices they were expecting. This outcome, in turn, produces more hesitancy. Simultaneously, consumers also expect lower rates to happen eventually.

With the impact of tax refund season effectively over, the vehicle market is seeing declining sales momentum. The next few weeks and months could be challenging if consumers en masse believe they are better off waiting to purchase.

The Fed will communicate updated forecasts and rate projections at the meeting in June. Hopefully, by then, they will see better inflation progress. But they will also likely see more evidence of slowing in the economy, like is happening in durable goods. If so, we could see cuts before the end of the year…  just not yet, nor any time soon.

Jonathan Smoke

Chief Economist

Jonathan Smoke leads Cox Automotive’s economic and industry insights team, which tracks key metrics and trends impacting both the wholesale and retail markets for vehicles informed by the proprietary data from the company’s businesses and platforms. For 28 years, Smoke has focused on translating data and trends into relevant actionable insights for the industries that represent the biggest purchases that consumers make in their lifetimes: real estate and automotive. Smoke joined Cox Automotive in 2017.