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Smoke on Cars

Keeping Rates Restrictive for an Extended Time Has Long-Term Implications

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As expected, the Fed raised the target for the Federal Funds Rate by three-quarters of a percentage point today, which was the fourth straight jumbo increase this year. The biggest news from the Fed’s move was the indication that future increases may be smaller and slower to come.

The Fed has now moved the target rate by 375 basis points (BPs), the most in any year since 1981. By December, the rate moves this year are expected to surpass 1981 and will only be bested by 1980.

The natural level for the short-term rate is widely thought to be 2.5%. With the Fed Funds Rate now at 3.75% – 4.00%, the Fed has tightened the choke on the American economy to the point that the engine is likely to stall out.

The Fed is not done with increases, but their new language indicates a more data-driven approach to where rates go from here: “… the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

This meeting did not produce any new dot plots, which define the likely rate path. The prior plots have suggested a slowing after today’s increase to a half point in December and another quarter point in 2023.

While we may be getting closer to the endpoint, the Fed has indicated they plan to keep rates high and restrictive until inflation has come down to their target of 2%.

Long-Term Implications of Higher Rates

Beyond the growing risk of recession, this restrictive rate level has structural implications for financing-dependent sectors like auto and housing. As a result, living with restrictive rates for more than a few months will have long-term implications for the industry and the country.

We have seen auto loan rates follow the Fed’s prior moves this year. With today’s increase and the plans to raise the target rate at least 50 BPs more, auto loan rates will likely increase by another 1-1.5 percentage points by year-end and potentially a bit more early in 2023.

Before long, consumers will be contending with auto loan rates not seen since 2001.

As a result of higher rates, consumers who are most payment sensitive have been falling out of the market. We see that clearly in subprime and deep subprime consumers disappearing. We also see a corresponding rise in the share of higher-income consumers at the expense of lower-income consumers.

Cash buying is also rising as consumers opt to pay cash instead of paying 8% or more on a new-vehicle loan or 12% or more on a used-vehicle loan. At historically high vehicle prices, cash buying is primarily an option for only the wealthy.

This has long-lasting implications for the vehicle market. Before the pandemic, the auto industry was already shifting towards more expensive vehicles with a move to more trucks, SUVs, and luxury vehicles at the expense of smaller, more affordable sedans. As the pandemic and supply chain issues then limited new-vehicle production, primarily the most profitable vehicles and the most expensive configurations have been produced. Now throw in restrictive rates for the foreseeable future and the industry must contend with a buying pool that will only reinforce a focus on wealthy consumers.

The used-vehicle market offers no affordable refuge. Since yesterday’s new market supplies the used market, affordable alternatives will also be limited. Like the new market, with the rate moves this year, the used-vehicle market is starting to see similar shifts in buyers, with higher-income consumers gaining share and subprime increasingly being priced out.

Higher Rates are Challenging Subprime Buyers

Through October, the weighted average auto loan rate across all loan types has increased by 2.8 percentage points to 10.6%. That increase causes the average payment to increase by more than 8% due to interest rate changes alone.

The challenges are more severe for lower credit tiers. In October, a deep subprime borrower, with a credit score under 580, saw an average rate of 18.2% on a new-vehicle loan and 21.8% on a used-vehicle loan.

No new vehicle being sold today can be financed with rates at that level to produce an affordable payment.

A $400-a-month car payment is an important target for many mainstream households, as it would consume 10% of the gross income for a household with $50,000 in income. The vehicle that comes closest is a 2022 Chevrolet Spark, but factoring in taxes, tags, and title and assuming a 10% down payment, the $400 target is unattainable.

Even though used prices have come down some this year, it is still difficult to find a used vehicle without substantial mileage or maintenance concerns that would produce an affordable payment without other expense challenges. In today’s market, subprime buyers are mainly limited to vehicles that are 6-9 years old and with at least 75,000 to more than 120,000 miles.

Due to the natural loss of vehicles that occurs over time, the older you must go, the fewer choices you have. Go back more than eight years, and you will find that fewer vehicles were manufactured during and coming out of the Great Recession.

The U.S. Market, More than Ever, is Dependent on Wealthy Buyers

With rates expected to go even higher and stay there for at least the duration of 2023, the auto market will become more dependent on cash-rich, higher-income, and higher credit-tier consumers. Manufacturers will focus on that demand pool, and the vehicle stock will be challenging for even more years to come by having fewer affordable options.

This affordability problem is not the Fed’s fault, but it is a side effect of making rates restrictive and keeping them there. Transportation in the U.S. is heavily dependent on personally owned vehicles. And unfortunately, an increasing share of the population is running out of options for affordable transportation.


Jonathan Smoke is the chief economist at Cox Automotive.

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