Fed Slows Hikes But Says Not Done Yet

As expected, the Fed raised the target for the Federal Funds Rate by half a percentage point today, which was a smaller increase than the four straight jumbo increases that preceded the latest move. The Fed’s biggest news was that the terminal rate, meaning the ultimate peak in rates for this tightening cycle, will be higher by at least 75 basis points (BPs).

This year the Fed has now moved the target rate by 425 BPs, which is the largest net change in any calendar year in history. The years 1979 and 1980 both had larger increases, but those years also saw cuts. This is the first time the Fed has ever moved rates so aggressively in only one direction in a single year.

The natural level for the short-term rate is widely thought to be 2.50%. With the Fed Funds Rate now in the 4.25% to 4.50% range, the Fed is now risking that monetary conditions, once rates reach the terminal point, could be near “terminal” for the economy as well, especially with the intent to move higher a few more times early in 2023.

Today’s announcement included new dot plots, which define the likely rate path, and new forecasts from participants. The plots indicate that the end of this rate cycle remains a few rate hikes away. The next three Fed meetings are in February, March, and May. The dot plots show no reprieve in 2023 once the peak is reached.

The updated plots affirm the Fed’s intentions to keep rates high and restrictive until inflation has come down to their target of 2%. Recent data have indicated that progress is being made on that front. That’s where the updated forecasts are even more telling. The Fed sees the unemployment rate increasing to 4.6% at the end of next year and staying elevated through 2024. That increase in unemployment implies at least 1.5 million job losses in the year ahead. Their revised GDP forecast indicates very anemic growth of 0.5%.

In 2022, a year of declining vehicle sales, we have seen auto loan rates follow the Fed’s moves with a lag. Auto loan rates have moved higher by a bit more than 3 full percentage points so far and likely have another one to two points to go before they peak. That level of rates has not been seen in more than 20 years.

Looking ahead, a weak economy with job losses is not good for vehicle demand. Payment affordability will be much more of an acute challenge in 2023 than what has been experienced over the last two decades.

As a result of higher rates, consumers who are most payment sensitive have been falling out of the market. 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.

That shift has the consequence of making manufacturers focus even more on the luxury market, further reducing the affordability of what is produced. The only hope for relief in the near term will be in the used market, where used-retail prices are finally starting to decline at an accelerating pace following a 13% decline in wholesale values this year since May.

Demand will continue to be challenged as long as rates continue to rise. Once rates peak and stabilize, depreciation will increasingly produce 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.

For much of the next year, we expect used-retail prices to help bring down overall consumer inflation, just as it has done this fall. When this chapter is finally over, used cars will have followed a transitory path up and then down, defined by the market forces of supply and demand.

The Fed’s actions influence demand. By reducing demand and tilting the new market to further favor wealthy consumers, supply will take longer to normalize. The auto market will be living with the aftereffects of this rate roller coaster ride for several years to come.

Jonathan Smoke is the chief economist at Cox Automotive.