Lift off, but to where?

Quick takes:

• Fed initiates tightening
• Risk of doing too little or too much
• Lessons from history
• What to expect this cycle
• CRE should stand firm

Lift off, but to where?

Last week the Federal Reserve raised the target fed funds rate by 25 basis points (bps), as we anticipated, the first hike in three years. Thus began the Fed’s process of tightening monetary policy to (attempt to) restrain inflation. Moreover, the Fed’s outlook took a hawkish turn, with committee members now anticipating another six rate hikes of effectively 25 bps each this year followed by roughly four more next year. This would occur while the Fed is also unwinding its balance sheet via quantitative tightening (QT). The Fed will now attempt to safely land the shuttle on a very narrow strip between doing too much and doing too little. But many questions now abound. What represents too much tightening? Too little tightening? Will tightening even work in the current environment? And what does it all mean for commercial real estate (CRE)?  

Too little

The U.S. economy has largely avoided the risk of too little tightening for most of the last four decades. Yet, that risk has become abundantly clear over the last year. The Fed funds rate remained near zero until last week. Older inflation metrics hit highs unseen in decades while some more recent inflation measures hover near record rates. Nonetheless, the Fed held near 0% on the belief that inflationary pressures would prove ephemeral and somewhat muted as the supply chain disruption abated and fiscal stimulus faded. What changed the Fed’s view? Like much in economics, supply and demand. Supply remained disrupted for longer than many anticipated as waves of the pandemic (including after the advent of vaccination) continued to stymie production and distribution. Meanwhile unprecedented fiscal stimulus, loose monetary policy, and the release of pent-up spending from 2020 unleashed massive demand into the economy.  The longer this persisted, the Fed fell farther behind the curve. Of course, the Fed cannot really influence supply, but higher rates could help to tamp down demand which could slow the economy and inflation. But what’s the risk of high inflation? In short, eventually inflation spirals to such a degree that revenue growth cannot keep pace with expense growth, earnings decline (or turn negative), risking significant layoffs, a plunge in production, and a painful recession. This represents the equivalent of traveling at a high rate of speed, slamming on the brakes, and then backing up quickly. 

Too much

Conversely, increasing rates too much can also produce a recession. This method caused most of the post-war recession in the U.S. As the cost of capital increases and access to capital becomes scarcer, borrowing and spending (particularly on capital items, which are interest-rate sensitive) declines, slowing demand and revenue for such goods. That typically results in layoffs that begin a cascade of reduced spending, additional layoffs in other industries, and ultimately a recession. The problem, of course, remains knowing the tipping point, r* (“r-star”). R-star is defined as the real neutral rate of interest that equilibrates the economy in the long run. It represents the real interest rate - neither expansionary nor contractionary when the economy is at full employment.

Lessons from history

When tightening monetary policy, the Fed has to walk a tightrope between too much and too little. Yet the rope seems ever tighter this cycle because inflation is running so high. The Fed has earned a reputation for failing to walk this tightrope adroitly. And periods of high inflation have typically ended because of a recession brought about by too much monetary tightening. Yet the Fed boasts a more mixed and nuanced record than many believe. Chair Powell himself recently mentioned three instances – in 1965, 1984, and 1994 – when the Fed raised rates to head off economic overheating without triggering a recession. Could the Fed do so again? Possibly. But navigating between inflation and growth will likely prove difficult, especially with the pandemic and geopolitical events complicating and muddying the situation. 

Adaptive learning

The Fed must proceed cautiously. While high inflation presents the most immediate concern, we should not discount the possibility of a recession if the Fed pushes too far. Afterall, the Fed cannot know r-star with certainty. While the economy can handle some tightening above r-star, just how much is unclear. Our proprietary model currently estimates r-star around roughly 2.5%. That gives the Fed some room to keep raising and reaffirms our view that the Fed will likely not be able to raise rates much (if any) beyond the last tightening cycle when it raised the target rate to a cyclical peak of 2.5%. Moreover, during the last tightening cycle the Fed’s rate forecast consistently exceeded the actual target rate, calling into question the viability of their current aggressive forecast.

10-Year Yield Minus 2-Year Yield

Over the last 40 years of tightening cycles, the Fed has consistently failed to raise the Fed funds rate back to pre-recession peak when tightening. It could do so this cycle. But it will have to proceed cautiously because it is effectively trying to hit dynamic targets – both inflation and growth should slow as it raises rates. That makes it easier to overshoot than if it aimed at static targets. It must adapt, like last cycle (and even like 1995), and back off if it pushes too much. The prospect of pushing too far seems more probable this cycle because the most interest-rate sensitive goods in the economy, such as housing and durable goods, remain in an excess demand situation. Such demand could prove harder to tamp down with higher rates than during a more typical business cycle. If so, the Fed could perceive rate increases as ineffective, driving it to tighten more aggressively, further increasing the risk of recession. The yield curve has already flattened considerably, indicating that the market believes even the Fed’s current forecast could constitute too much tightening. It does not seem at all obvious that a tightening-induced recession that tames inflation is a superior outcome to moderate, yet tolerable inflation coupled with modest economic growth - if the Fed can engineer it. The flight path for interest rates looks turbulent, but not impossible. 

|  What it means for CRE  |

We continue to reiterate the weak and typically negative relationship between interest rates and cap rates. Based on empirical evidence from the last four decades, fear of rising rates seems misplaced, at least as a first-order effect. The key risk to the performance of CRE remains the health of the overall economy and of course rising rates put the economy at risk. Risks have clearly shifted to the downside and the probability of a recession is rising. But for now, as we stated last week, the outlook for the economy and CRE remains cautiously optimistic. 

|  Thought of the week  |

During the Weimar Republic, a trillion-fold increase in inflation occurred in roughly four years.