July Delivers Higher Auto Rates with the Fed Promising More Ahead

As widely expected, the Fed raised the target for the Federal Funds Rate by three-quarters of a percentage point today as it remains steadfast in its goal to rein in inflation. Combined with the increase made in June, the Fed has now moved the target rate more in two months than at any point since 1981, and they are not done yet. The Fed has now increased the target rate this year by 2.25 percentage points and plans to move rates to 3.5%, if not more, by year-end.

The policy decision by the Fed Open Market Committee was unanimous. Financial markets reacted positively to the Fed’s announcement.

With the moves completed through today, the current short-term rate level is back to what the Fed considers as neutral, which means that rates are viewed as neither stimulative nor restrictive. Any moves higher from here will, by definition, be restrictive. If the Fed does push rates into restrictive territory, then the Fed wants vehicle sales to remain soft, but not too soft, even as supply builds. That would also lead to less new-vehicle inflation.

In Chairman Powell’s press conference following the announcement, he indicated that the expected target for year-end of 3.5% is still where they see rates heading. If rates reach the year-end target, it will be the highest level for the Fed target since 2007. The chairman also emphasized that future moves will be data-dependent, which means rate changes could be less or more depending on how inflation and economic conditions evolve.

The balance sheet reduction, also known as quantitative tightening, began on June 1 and is proceeding as planned with a decline of $47.5 billion per month. The reduction will accelerate to $95 billion per month by September. These actions should drive longer-term rates higher, whereas rate policy changes, like the one announced today, have a more direct impact on short-term rates.

So far this year, the Fed’s movement has impacted the mortgage market more than the auto market. Before today’s changes, the average 30-year mortgage rate had declined by 15 BPs in July, but it had already increased by almost 2.5 percentage points (250 BPs) at the end of June compared to the start of the year.

The term length of a loan determines the impact of a change in rates on the average payment. The longer the loan term, the greater the payment inflation. A 1-point change in a 30-year mortgage has a 12% impact on the average payment, all other factors equal. A 1-point change on a 6-year auto loan has a 3% impact on the average payment.

Therefore, the rate movement that has already happened has had a much more negative impact on the real estate market than on the auto market. That 2.5 percentage point change in mortgage rates has caused a 30% increase in the average payment. That negative impact is evident in the home sales data, as new and existing home sales were down 15% year over year in June.

Through mid-July, the average auto loan rate has increased by about 1.5 percentage points for the year. That means that the average payment – all else being equal – has increased by just shy of 5% due to the Fed’s actions. With rates expected to increase even further before year-end, financing costs will make purchases more challenging, especially at lower price points and in the used vehicle market where rates are often higher.

However, the key issue for the new-vehicle market up until now has not been demand or affordability, but limited production because of supply chain challenges. With no evidence yet of inventory building, new-vehicle demand is at least keeping up with slowly growing deliveries.

If new-vehicle loan rates increase further, by as much as two full points, demand could diminish just as production and product availability improves. In that scenario, we could see the return of some discounting and incentives. This has not happened yet, as we continue to observe new-vehicle price inflation, limited discounting, and record low incentives.

That higher rates will lead to lower new-vehicle sales is not a foregone conclusion. As the new market has shifted to become more concentrated in higher price points, the industry benefits from having higher income and higher credit quality buyers who are less negatively impacted by the current inflation trends. At this end of the credit spectrum, the limitation on transactions has been supply, and the limitation going forward is likely to be more about confidence than capability.

In the used-vehicle market, higher rates and inflation’s impact on subprime buyers are preventing demand from improving even as vehicle prices decline. Used-vehicle inventories have moved closer to normal levels, and used vehicles are depreciating again.

In our bifurcated economy, used-vehicle buyers are more likely to be more negatively impacted by higher prices for energy, food and rent. The declining subprime share of transactions reflects this pressure. With auto loan rates continuing to rise, the U.S. vehicle market is becoming even more dependent on higher-priced product and higher-income buyers. As a result, the dream of a new vehicle is fading from view for more American households.

Jonathan Smoke is the chief economist at Cox Automotive.