Fed speak and data this week

PCE not going gently

Inflation is not making the Fed’s job easy. Both the headline and core PCE indexes exceeded expectations in January. While the consumer price index (CPI) has most visibly grown over the last year, the core PCE remains the Fed’s preferred inflation measure. This bump in inflation during January reflects what we already saw in other inflation measures such as the CPI and the producer price index (PPI). Why? Nominal consumption for January exceeded expectations. Real spending fell in line with expectations, but that level of spending showed a notable acceleration from fourth quarter’s spending pace. Somewhat sticky inflation represents the downside of resilience in the economy which we mentioned last week.

4Q GDP a bit softer than expected

The second look at GDP growth during the fourth quarter came in a bit softer than expected, with growth revised down slightly. The main culprit, household spending, did not increase as much as previously believed. Yet, business investment increased more than previously calculated offsetting some of the revision to consumption. Most other major categories changed relatively little versus the initial estimate. Net, these changes did not alter 2022’s growth rate which remains at 2.1%. Thus far in 2023 the economy is maintaining momentum. But we expect growth to slow in the coming quarters.

Labor market remaining tight

The labor market continues to remain incredibly tight. Weekly initial unemployment claims stayed below 200,000 for the most recent week. Continuing claims also remained at relatively low levels. Despite dour headlines, layoffs continue to hover near historically low levels and the number of open jobs remain elevated. Companies remain reticent to lay off employees due to the massive ongoing labor shortage. Moreover, many laid-off employees are getting rehired, particularly technology workers. We expect the labor market to weaken as the economy slows, but less than would occur during a typical economic slowdown.

Home sales generally remain weak

Existing home sales for January declined more than anticipated, falling for the 12th consecutive month. While the rate of decline has slowed in recent months, the annualized January sales pace is the lowest since January 2010 when the housing market was still recovering from its implosion during the global financial crisis. Although new home sales for January surprised to the upside, they represent a minority of overall home sales. With overall sales declining, housing prices continue to slide. Prices for existing homes fell for a seventh consecutive month. Prices for new homes have generally fallen since October, with another decline in the January data. As we mentioned last week, mortgage rates are driving the housing market. Although mortgage rates have backed off their recent highs, they remain elevated enough to limit sales and construction activity, hitting both demand and supply. With housing still expensive, the Fed is effectively betting that demand for housing will continue to fall faster than supply, further cooling the housing market and easing the shelter component of inflation.

Speak(ing) of the Fed

While no Fed meeting occurred last week, it was the Fed’s own words in the release of its minutes from the prior meeting that riled up markets. The minutes suggested that voting members remained committed to ongoing rate increases. While the Fed did not produce an updated fed funds forecast at its last meeting earlier this month, the commentary pushed market expectations for the fed funds rate upward. The terminal rate now peaks at a range of 5.25% to 5.5% in the current market estimate. Markets responded to these changes with equity markets sliding and interest rates increasing, especially at the short end of the yield curve. Most committee members continue to support hikes of 25 basis points (bps). The recently released PCE data should only further cement this view. 

We remain concerned about the risk of the Fed overshooting. Although the lag between rate hikes and their impact on the real economy has decreased over time, it nonetheless persists. Therefore, the economy has not yet felt the full impact of the Fed’s hikes, which should play out over the course of 2023. The voting members at least acknowledged the lag and favored slowing the pace of rate hikes to better analyze their impact on the economy. But the farther they go, the greater the risk of tipping the economy over into recession. 

What it means for CRE

Typically, rising interest rates suggest a stronger economic environment which generally portends good things for commercial real estate (CRE) performance. But things seem somewhat different during this phase of the business cycle. Higher interest rates are (at least partially) causing the slowdown in the economy and therefore represent a headwind to the CRE market. Right now, because ongoing momentum is contributing more to higher interest rates than to improvement in property market fundamentals, they could represent a net negative for the CRE market. That’s not to say that we should root for slowing in the economy. But it serves as a reminder that we have not seen dynamics of this slowdown in the economy and CRE market since at least the early 1980s. And the structure of the CRE market has changed considerably since then. This is contributing to the sense of caution observed in the market today.

Thought of the week

Although it has fallen from its recent peak, the savings rate remains elevated relative to pre-pandemic levels.