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Smoke on Cars

Fed Raises But Prepares to Shift to “Wait and See” Mode for Uncertain Summer


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The Fed raised a quarter point today, which was widely expected. What was more important was the lack of language suggesting additional firming was anticipated, which is the Fed’s way of saying further increases are less likely than not.

The increase was the tenth in a row. The Fed has raised the Fed Funds Rate from 0% at the lower bound fourteen months ago to 5% now.

Economists widely believe that the natural rate is likely 2.5%, so in a little more than a year, the economy has gone from too low to twice as high. As a result, we have seen interest rate-sensitive sectors like housing and the used-car market slow down. We have also seen second-order effects like the failures of banks.

The Fed seems to be willing to accept a recession and what is likely to be at least 4 million jobs that will be lost as a result to bring inflation down to a 2% target.

The rate increases we have seen have limited who can buy vehicles. We have seen more evidence of pressure on demand from declining sales in the used market, where rates are more reflective of financial market conditions, sales have lost momentum this spring, and are now down compared to last year. And last year was not a good year. We’ve also seen consumers with lower income and lower credit quality have materially dropped out of the new-vehicle market because of the combination of higher rates, tighter credit, and high vehicle prices.

The average used auto loan rate hit 14% in March. In April, rates retreated some as yield spreads narrowed from how much they had widened during the worst of the initial banking crisis days in March. The average used rate in April was 13.5%, which was up 3.5 percentage points from a year ago.

The Fed acknowledged that credit conditions have tightened over the last few months. Still, their unanimous decision indicates they remain more worried about inflation than the financial system’s fragility or the U.S. economy more broadly.

Recession risk has risen to be more likely than not over the next 18 months. The Fed’s actions add to that risk as higher rates expose more challenges to the banking system and inevitably lead to more credit tightening for businesses and consumers alike.

The next few weeks and months will be pivotal to a recession materializing later in the year. The Fed meets in each of the next two months. Between now and those summer meetings, the U.S. will run out of money without a change in the debt ceiling. The politics around that decision make it very unlikely that we will see any fiscal action to help an ailing economy.

This summer may be brutal for its impact on consumer confidence and credit conditions, and that does not bode well for retail vehicle demand. Surprisingly, the new market has been stronger than expected so far this year and appears to be gaining momentum. April sales surprised on the upside. However, do not interpret the performance so far as an indication that the new-vehicle market is immune from higher rates and a slowing economy.

The new-vehicle market is likely seeing less retail sales growth than we otherwise would have seen if the only limitation was supply, as it has been over the last two years. New-vehicle supply is up about 70% from a year ago. Rates peaked in March when the banking crisis added to credit tightening, and the average new rate for an auto loan almost reached 9%. The average new rate declined to 8.8% in April, up 3 percentage points from a year ago.

Some of the strength so far this year in the new market is undoubtedly a result of pent-up demand finally being able to be met by more supply this year. Strong sales to date have also been supported by sales into fleet and by increasing incentives from manufacturers that are keeping new auto loan rates attractive for consumers.

It is tough to project where consumer rates head from here. Rates may have already peaked, but it is also possible that further credit tightening could lead to wider yield spreads and higher rates for consumers.

Volatility is most likely for the near term. The bond market is moving quite a bit day to day as financial markets fret about inflation, bank failures, recession risk, and the politics around the debt ceiling.

Rates on new-vehicle loans will likely be less affected than in the used market, as manufacturers increase incentives, including buying down rates, to keep them more attractive.

If we avoid a recession, it is possible that we are near the peak in rates and consumers could see lower rates later in the year. Even if the Fed leaves the Fed Funds Rate at its peak level, if yield spreads narrow, rates could come down and the March highs could be the worst of it.

However, given the uncertainty, used loans and loans to consumers with less-than-perfect credit may be harder to get and feature more onerous terms than what we have seen over the past two years. For example, lenders could require a higher down payment or not approve loans with longer terms, which help keep payments manageable.

I would not bet on lower rates or materially better credit conditions for consumers before the summer is over. That said, if new-vehicle supply continues to be up compared to last year, there will be no shortage of 2.99% APR or better special financing opportunities for new vehicles.

All bets are off if the U.S. tips into recession.

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.

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