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Smoke on Cars

Fed Makes First of Seven Rate Increases Expected in 2022


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The Fed followed through with its widely telegraphed plan to start raising the target rate for the Federal Funds Rate. The target was increased by a quarter of a point, as expected, but the Fed indicated that six more quarter-point rate increases will likely follow before year-end, and that was more than expected.

Rate projections indicate that the target rate would be near 1.9% at the end of 2022 and then increase to 2.8% by the end of 2023.

In addition to increasing rates, the Fed announced it would start reducing its balance sheet at a subsequent meeting. The expansion of the balance sheet, also known as quantitative easing, ended earlier this month. Shrinking the balance sheet, also known as quantitative tightening, could push longer-term rates higher even more than the short-term rate moves.

The actions by the Fed today are considered much more hawkish than their position after the first meeting of the year in January. A key difference since January was the Russian invasion of Ukraine, which has accelerated inflation instead of seeing inflation peaking and starting to recede. The Fed statement acknowledged the risk: “The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.”

Updated forecasts for the Fed reflected higher expectations for inflation in 2022 (4.3% on the personal consumption expenditure index vs. 2.6% in their previous forecast). Inflation erodes real economic growth, so their forecast for real GDP growth declined from 4% previously to 2.8%. Forecasts for unemployment were unchanged through 2023, as slowing growth is not expected to damper the strong labor market.

Financial markets are concerned about the Fed’s ability to steer the U.S. economy into a “soft landing” from the overheated growth that produced a 40-year high of inflation of 7.9% on the CPI in February. Shorter duration bond yields, like on the 2-year U.S. treasury, have moved higher while longer bond yields, like the 10-year, have not moved as much. This results in a flattening of the yield curve, which is an ominous signal indicating that the risk of recession is rising.

Bond yields moved higher in response to the aggressive Fed language and projections. The yield on the 10-year, which is strongly correlated with consumer rates on mortgages and auto loans, had already moved higher by about two-thirds of a point so far this year. Yields are now higher than at any point since May 2019.

Following these moves in yields, consumer rates have been moving higher this year on all types of loans. The Fed’s latest plans, and the financial market’s response to them, are likely to lead to even higher rates in 2022 than previously expected.

The mortgage market has been far more reactive than the auto loan market. Prior to today’s changes, the average 30-year mortgage rate had increased by more than a full percentage point since December. The average auto loan rate had moved only about half a point over the same time. The difference likely reflects the relative attractiveness to lenders to put more capital in auto lending than other types of consumer loans.

With rates expected to increase by more than a point beyond the increases observed so far, financing costs will quickly make financing big-ticket purchases more challenging. This is exactly what the Fed wants to see. As demand for real estate and goods slows, the rate of price increases should slow as well.

For consumers planning to get the lowest possible monthly payments in 2022, the clock is ticking. Keeping terms, prices, and down payment assumptions constant, an increase in an auto loan rate of a full percentage point adds about 3% to a monthly payment on the average new vehicle. The impact on mortgages is twice as severe given the longer loan term. One percentage point increase on a mortgage rate adds 6% to the typical mortgage payment.

The spring is looking much more attractive to buy a vehicle than in recent months despite the rate increases that have happened so far. Measures of new and used prices have declined to start the year, and supply is relatively better than it was throughout the second half of last year. With supply likely to tighten in the months ahead with new production challenges emerging in Europe from the war in Ukraine and in China from surging COVID cases, prices are more likely to rise than fall, especially in the new-vehicle market.

Jonathan Smoke is the chief economist at Cox Automotive.

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