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Smoke on Cars

The Race Is On: Low Vehicle Payments Versus the Fed

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The Fed raised the target for the Federal Funds Rate by three-quarters of a percentage point today as it becomes more aggressive in its quest to rein in inflation. The increase in the target rate was the largest in almost 28 years. The Fed has now increased the target rate by 1.5 percentage points and plans to move rates by even more before year-end.

The policy decision by the Fed Open Market Committee was not unanimous, as one Governor preferred a half-point increase. Financial markets reacted positively to the Fed’s announcement.

The committee’s rate projections indicate that the target rate would be near 3.4% at the end of 2022 and then increase to 3.8% by the end of 2023. These levels are much higher than prior targets. Chairman Powell indicated that July would likely see a half- to three-quarter point increase but specific changes would be determined meeting by meeting. If rates reach the year-end target, it will be the highest level for the Fed target since 2007.

Updated forecasts from the Fed reflected higher expectations for inflation in 2022 (5.2% on the personal consumption expenditure index vs. 4.3% in their previous forecast). Their forecast for real GDP growth declined from 2.8% previously to 1.7%. Forecasts for unemployment were increased slightly as a slowing economy should cool the labor market as well.

The financial market expects a three-quarter point increase in July, a half-point increase in both September and November, and a quarter-point increase in December. That implies 200 basis points of increase to come on top of the 150 basis points already increased and essentially lands rates consistent with the Fed’s revised plans.

The reduction of the balance sheet, 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 have a more direct impact on short-term rates.

Bond yields moved lower today. The yield on the 10-year, which is strongly correlated with consumer rates on mortgages and auto loans, had already moved higher by nearly two full percentage points through yesterday. Yields are now higher than at any point since February 2011.

Consumer rates have also rapidly moved higher this year on all types of loans. The Fed’s latest plans will likely push rates even higher as the year progresses.

The mortgage market has been far more reactive than the auto loan market. Prior to today’s changes, the average 30-year mortgage rate had increased by almost three full percentage points since the end of December. That movement alone increases mortgage payments by almost 20%.

Auto loan rates have also moved higher but not by as much. Average auto loan rates have moved up about a full percentage point year to date. That movement increases the average payment by about 3%.

With rates expected to increase even more before year-end, financing costs will make financing big-ticket purchases more challenging. This is precisely what the Fed wants to see to cool the economy.

However, it creates an uncertain future for the new vehicle market when the key issue continues to be production and supply chain challenges leading to extremely limited new vehicle supply. Despite higher rates, we are not seeing a buildup of new-vehicle supply. This may change when production improves substantially, but it has not happened yet and likely won’t before next year. As a result, we continue to see new vehicle price inflation, limited discounting, and record low incentives.

The Fed’s actions will not fix the supply problem, but when production does eventually start to improve, demand may not be able to keep up without a material change in incentives and pricing.

We continue to see more normal trends this year in the used vehicle market. Both retail and wholesale used supply have returned to normal, and as a result, used vehicles have returned to being depreciating assets. The good news for the Fed is that used vehicles will not likely contribute to inflation going forward. Still, ironically the supply and affordability issues in the new-vehicle market boost demand in used. As a result, demand will likely stay relatively strong in used even with rates moving higher.

However, we are seeing indications of weakness in lower price points, likely due to the most acute financial pressure being on the most price-sensitive segments. As a result, subprime and deep subprime purchase activity is declining. This is less a story about rate movement and more about the impact of inflation being felt the most by these households. The Fed’s actions in increasing rates are not likely to help much with the cost of energy, food, and rents, at least in the near term.

All of this means that rates are likely to increase even more in the months ahead, and affordability will get worse and limit future demand potential. Consumers with great credit can often get better than average rates in the new vehicle market through special financing offers from manufacturers. However, with tight supply, the number of such offers has been dropping so far in 2022.

The next best alternative to get the lowest rate is in certified preowned vehicles. Consumers have more good news in the used market where normalizing supply has led to lower prices. Used supply is relatively robust, but it is harder to find “nearly new” vehicles like the certified units that offer the lowest rates. The bad news is that finding the lowest payment may be a race against the Fed, and the Fed’s not even halfway done with their rate plans.


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Jonathan Smoke is the chief economist at Cox Automotive.

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