The Fed and inflation. Again.

Quick takes:

• Economy maintains momentum in early December
• Labor market slowing
• Inflation easing, but not quickly
• Fed to set to raise 50 basis points
• CRE poised for slowing and rebound

Stop us if you’ve heard this one before: our focus this week is on the Fed and inflation. While other data continue to tell us much about the health of the economy, the rubber meets the road with inflation and the Fed’s response. With inflation slowing but still elevated, we expect the Fed to continue to tighten as it heads into the new year. After that, the road forward looks far more uncertain.

First, the good news

We received what would normally get classified as good news from the economy last week. First, the ISM Services index for November increased surprising on the upside relative to expectations. The services sector of the economy continues to outperform manufacturing and rebounded following declines in September and October. A reading above 50 signals expansion and services continue to expand at a healthy pace. They have now expanded for all but two of the last 154 months.

Business productivity growth grew faster than previously estimated during the third quarter after declining notably during the previous two quarters. Unit labor costs, a measure of cost per output, got revised downward. That also reversed a notable trend from the prior two quarters when unit labor costs increased at a high rate. Though the longer-term trend shows declining productivity and accelerating costs, even some temporary easing of each is welcome at this stage.

Finally, consumer sentiment in early December increased from November, exceeding expectations. But the number remains far lower than in recent years. Helpfully, it looks like consumer inflation expectations have not yet become unmoored, a helpful sign for when the economy ultimately shifts beyond high inflation to something more typical.

The bad news that might be good news

Initial weekly jobless claims increased last week, and continuing claims continued to trend upward, rising to their highest level since February. Overall, the labor market remains tight, probably too tight for the Fed’s liking. Therefore, while we would not normally view these trends as positive, any sign of cooling in the labor market might help to keep the Fed from pushing too far on rate increases.

Producer inflation slowly slowing

The good news that’s still bad news

The producer price index (PPI) for November came in slightly higher than expected. We caution, however, that inflation data from month to month can prove incredibly volatile and difficult to predict. We continue to alternate between periods when inflation comes in cooler than anticipated, and markets respond positively and periods when inflation comes in hotter than anticipated and markets respond negatively. Yet through the monthly swing, the overall trend shows inflation cooling over time. Year-over-year headline and core PPI inflation continues to trend downward over time, though not likely fast enough for the Fed’s liking. PPI inflation should continue to follow this downward trend but seems unlikely to decelerate much in the short term. 

The Fed

All eyes will be on the Fed this week with its last meeting of the year. The Fed will get a look at the November consumer price index (CPI) data before its decision. We anticipate that headline and core CPI will continue to slowly decelerate, but that should keep the Fed on track to raise rates by 50 basis points (bps). This would be the first time since March that the Fed didn’t raise by 75 bps. The Fed and some of its noteworthy speakers have signaled this likely approach. Additionally, we expect the Fed to raise its guidance for the fed funds rate moving forward. We now believe the terminal rate will reach above 5% next year, with the Fed likely to hold at that level for at least a couple of quarters before starting to lower rates, likely in late 2023 or 2024. If so, the economy can still avoid a recession but that will largely depend on the Fed. For now, we continue to see a 40% to 50% chance of recession next year, contingent upon Fed activity.

What it means for CRE

Commercial real estate (CRE) demand has weathered interest rate increases and high inflation relatively well. While not unscathed, performance has generally held up. Even within lagging sectors, such as office, pockets of strong performance abound. Supply across property types remains mostly in check, outside of some submarkets. If, and we stress if, the Fed halts rate increases near 5%, we see a mostly positive path forward for CRE tenant demand. There may be a few bumps in the road in 2023 as the economy slows, but we expect any disruption to be relatively short and shallow. Underlying economic momentum remains positive and labor market strength and consumer spending should rebound relatively quickly from any slowdown. Such a turnaround would benefit CRE. If inflation continues to slow as expected, that should provide consumers with a boost and potentially even push real interest rates into positive territory.

Thought of the week

Oil prices in the U.S. have returned to early January levels, providing consumers with a boost during the holiday season.