Fed Rate Policy Liftoff Set; Auto Loan Conditions Likely to Become Less Favorable

The Fed is moving to tighten U.S. monetary policy in 2022. At its first Fed meeting of the year, the Fed announced that it will soon be appropriate to raise the target rate for the Federal Funds Rate. 
 
The Fed’s language was an indication that rate increases could begin in March, which is when the next scheduled meeting will occur. That is also following the end of bond buying, which the Fed announced would end in early March. Despite wide speculation that plans for quantitative tightening could also be signaled, the Fed did not announce plans for reducing the size of its balance sheet, and instead reiterated that its primary tool will be using the Federal Funds Rate. 
 
Financial markets are concerned about the Fed’s balance sheet, but the Fed resisted setting expectations for more concrete plans likely because substantial uncertainty remains about the path of the economy. 
 
Overall, this move was seen as relatively dovish, as the range of possible moves included acting now and communicating plans for quantitative tightening. However, it was a clear initial move to slow the economy to control inflation through traditional rate policy. It also signals that financing conditions for consumers considering big purchases like cars and homes are not likely to be as attractive going forward. This is indeed what tighter monetary policy is supposed to achieve—a slowing in demand. 
 
The January meeting’s official statement noted that indicators of economic activity and employment have continued to strengthen, but that sectors most adversely affected by the pandemic are being affected by the recent sharp rise in COVID cases.  
 
With inflation at the highest level since 1982, the Fed previously communicated expectations for three quarter-point rate increases in 2022. The January meeting did not include updated rate dot plots, but financial markets are expecting four quarter-point rate increases for the year. 
 
Longer-term bond yields moved up modestly this afternoon in response. Yields have already moved higher by more than a quarter point so far this year. This has left yields higher than at any point since early January 2020, which was before the pandemic began.  
 
Consumer loans like auto loans and mortgages are more directly related to these longer-term yields rather than the Fed’s short-term rate policy. While 10-year yield has moved up about a quarter point so far this year, not all consumer loans are following that exact path. 
 
The mortgage market has been far more reactive than the auto loan market. The average 30-year rate has increased by more than 40 basis points so far this year. The average auto loan rate has moved less than a quarter point.  
 
The varied moves in actual consumer rates reflect differing trends in the spreads that lenders manage relative to the benchmark rates like the 10-year. The moves so far in January indicates spreads are narrowing for auto loans but widening for mortgages. 
 
That means that auto credit has been come even more favorable and consumers are seeing the best offers on rates relative to bond yields than we have seen since at least 2015. The mortgage market is seeing the opposite story—it is becoming less favorable relative to the cost of capital. 
 
For consumers planning to finance a vehicle purchase in 2022, these favorable conditions are not likely to last. Eventually, one or more factors will turn less favorable in auto loan credit. 
 
As the Fed increases rate policy, the 10-year is likely to move similarly. At the same time, we are seeing auto loan performance normalize from what had been very low levels of delinquencies and defaults earlier in the pandemic. In addition, we are expecting vehicles to start depreciating again in the back half of this year. Collectively these trends suggest that the lowest of auto loan rates were in December, and rates could be a full point higher by the end of the year. 
 
It is possible that the rates offered by lenders continue to be relatively favorable relative to what the Fed is doing and what the bond market is doing, but lenders are likely to manage risk in other ways if yield spreads do not expand. For example, higher down payments could be required, terms offered could be shorter thus increasing payments, or lower credit applicants may have a harder time getting approved. 
 
It is ironic that credit is most favorable now while supply continues to be constrained. Supply is expected to improve as the year progresses, but financing costs are likely to increase as well. This suggests that demand should be strongest in the near term while supply is likely to be higher in the longer term.  

Jonathan Smoke is the chief economist for Cox Automotive.