Ending on a hopeful note

Quick takes:

• PI increased less than expected
• Inflation slowing down
• Fed hikes 50 basis points
• Terminal rate increases
• CRE space market proving resilient 

Ending on a hopeful note

As we close out 2022, the year is ending on a hopeful note. First, inflation continues to show signs of slowing, faster than anticipated. Second, the Fed continued to raise rates but downshifted the magnitude of increase. Together, these developments provide hope that the economy can avoid the worst-case scenario and reach a soft landing.

CPI slowed more than expected

While the Fed looks at various measures of inflation, the consumer price index (CPI) remains particularly important because of the CPI’s focus on consumers and the heights it reached this year. The disinflation observed in the November reading occurred across almost all categories. Headline and core inflation came in lower than anticipated and continued to decrease on a year-over-year basis. Goods inflation also continued to slow. The key outlier remained core services. Yet here the data is likely misleading. Shelter inflation in the CPI continues to present a thorny issue. Effectively, Census calculates CPI like a moving average, a reflection of in-place rents and not just a measure of the change in current asking rents. Setting aside the pros and cons of that methodology, it likely means CPI is understating the current reality with house prices already declining and asking rent growth for apartments slowing. One could argue that CPI understated inflation on the way up, but that dynamic also works on the way down. Therefore, inflation could be slowing faster than the data suggests.

Another key question concerns the use of year-over-year inflation as the key guide. Again, setting aside pros and cons, we would simply say that method includes a lot of inflation that occurred in the past and could mislead as to how quickly inflation is slowing. For something a bit more current, if we look at three-month inflation trends we can see that both headline and core CPI have slowed considerably from highs this summer and have fallen into ranges more typically seen during the previous business cycle when inflation remained benign. During most three-month periods, core and headline CPI tend to stay with plus or minus 1%. Both have now fallen back into that range.  To be fair, this also happened during the third quarter of 2021 before inflation rebounded. But inflation faces greater headwinds today than it did then. 

3-month inflation quickly falling
 

The Fed

The most noteworthy of those headwinds comes from the Fed in the form of higher interest rates. While improved supply chains also played a role, higher interest rates have become the swing factor for both inflation and economic growth. Last week the Fed raised rates by 50 basis points (bps), as expected. The 7th rate hike of the year brought the target rate to a range of 4.25% to 4.5%. It was the first hike of less than 75 bps since March when the Fed began tightening. By our estimate this pushes the fed funds rate farther into restrictive territory. As we have previously discussed, these rate hikes are already having an impact on the most interest-rate sensitive parts of the economy such as housing, technology and financial activities. As we noted last week, we also see slowing in the labor market. That is important because the Fed will likely need to see slowing in inflation and the labor market (most directly via wage growth) before it will begin easing again. For now, with the slowdown that’s already occurring in the underlying economy and inflation, we expect the Fed to raise the target rate to around 5% (plus or minus) and likely leave it there for most of 2023. That agrees with the Fed’s new forecast which now predicts the terminal rate rising to 5.1% before rate cuts arrive in 2024 and 2025. 

What it means for CRE

We continue to believe that a recession is not inevitable, and the economy can reach a soft landing. However, that highly depends on the Fed. With inflation already slowing faster than many anticipated, it demonstrates that the combination of improved supply chains and higher interest rates can slow inflation down. We expect both to continue working as supply chains continue to heal and higher rates continue to restrain demand. That also means a downturn in the commercial real estate (CRE) space market is also not inevitable. Supply growth remains limited and some property types, such as industrial and multihousing, will enter the new year with momentum, even if slowing. Retail continues to prove itself more resilient than many think it is, constantly reinventing itself. And even office continues to have pockets of strength amidst heightened uncertainty. CRE still has a lot to look forward to in the new year, even with the challenges it will face. 

Thought of the week

Consumers will likely spend close to a trillion dollars this holiday shopping season.

Note: Economic Insights will be on vacation during the holidays. It will return in the new year. Happy holidays.