The Fed raised the target for the Federal Funds Rate by a quarter percentage point today, as expected, which was the smallest increase since the first of seven increases in 2022. Last year’s increases resulted in the largest sustained one-way move in rates in Fed history. The biggest news from the Fed today was that they still deem ongoing rate increases as appropriate. In other words, they are not done, but the extent and timing of additional rate increases are unclear.
The natural level for the short-term rate is widely thought to be 2.5%. The Fed Funds Rate is now in the 4.50% to 4.75% range. Going forward, and as we have noted before, the Fed is risking that monetary conditions, once rates reach the terminal point, could be “terminal” for the economy as well, especially with the intent to move higher a few more times this year.
Today’s announcement did not feature new dot plots, which define the likely rate path, or new forecasts from participants. The Fed’s prior projections suggest the target for the Fed Funds Rate remains above 5%, and the Fed expects a slowing economy and a rising unemployment rate as a result.
Auto Market and Consumers Feel Impact of Fed’s Decisions
Last year was a year of declining vehicle sales, with demand negatively impacted by increasing auto loan rates that followed the Fed’s moves with a lag. Auto loan rates increased by more than 3 full percentage points in 2022.
Auto loan rates have continued to move higher so far in January. As of the start of this week, the average new auto loan rate was 8.41%, up from 5.30% in January 2022. The average used rate also moved higher in January to 12.88%, up from 9.40% last year.
With all other factors held constant, this level of rate change causes a 10% impact on the monthly payment. However, other factors were not, in fact, constant. New-vehicle prices increased. Credit conditions tightened, leading to less flexibility on terms. As a result, the average new-vehicle loan payment increased by 13% year over year in December. The estimated typical monthly payment for a new vehicle increased to $777 in December, which was a new record, according to the Cox Automotive/Moody’s Analytics Vehicle Affordability Index.
As a result of higher rates, consumers who are the most payment sensitive have been knocked out of the market altogether. We have seen this most clearly in subprime and deep subprime consumers disappearing from both the new and used markets. We also see a corresponding rise in the share of higher-income consumers at the expense of lower-income consumers.
As a result of that shift, manufacturers are focusing even more on the luxury market, reducing the affordability of what is produced. The luxury share of the new-vehicle market increased to 17.8% in 2022, up from 16.4% in 2021. The richer mix contributes to new-vehicle price inflation. The average new-vehicle price of $49,507 in December was a new record, according to data from Kelley Blue Book.
New-vehicle prices are not likely to decline much, if at all, in the absence of a recession. Despite some inventory level improvements, the market is still supply-constrained, and vehicle parts and labor continue to see strong inflation. Rates are yet to peak and will likely remain elevated, so new-vehicle affordability will worsen in the year ahead.
Used Market May Contribute to Vehicle Affordability Relief
The only hope for vehicle affordability relief in the near term will be in the used market, where declining used retail prices are starting to create more buying opportunities. This has led to January seeing positive momentum in used retail sales. However, the reduced level of new vehicle production since 2019 and the shift towards more expensive vehicles that were produced and sold means that supply will be constrained in the used market for several more years.
If the economy avoids a recession, once rates peak and stabilize, used demand should improve as depreciation will lead to even more buying opportunities in the used market. Those opportunities will help to stabilize vehicle values and return the market to seeing normal depreciation rather than the abnormal increases and decreases the market has experienced since 2020.
However, if the Fed’s actions cause consumers to pull back and businesses respond by cutting jobs, retail demand for new and used vehicles will decline. Pent-up demand in the face of a declining economy with two to three million job losses will not save the vehicle market if prices and rates remain high.
As is clear from the still hawkish stance from the Fed communicated today, recession risk in 2023 remains elevated. The Fed may still avoid going too far if there is hard data that leads them to alter their course away from more increases by the next two meetings, which are March 22 and May 3. That’s the future, though. In the near term, we know vehicle affordability is the industry’s biggest issue, and nothing the Fed reported today is likely to change that fact.
Jonathan Smoke is the chief economist at Cox Automotive.