Not easy

Quick takes:

• Inflation remains stubbornly high
• Fed to remain aggressive
• Trade-off between prices and employment coming
• Fed’s actions have global ramifications
• CRE’s short-run depends on the Fed

Despite some perceptions, managing the economy seldom proves easy. Its cyclical nature, with periods of tumult following periods of relative calm, means that challenges are always lurking. Policymakers now find themselves confronted by one of the more daunting environments in decades, with high and intractable inflation bearing down on the economy. What do recent inflation readings tell us? How will the Fed likely respond? And what’s most at risk?

Stubborn inflation

Once inflation began to rise, the battle to bring it down became far from easy. Data released last week served as a reminder of that (if one were needed). The producer price index (PPI) for September showed that headline PPI came in above expectations while core PPI matched. That produced a deceleration on a year-over-year basis in headline and an acceleration in core, with both greater than anticipated. The consumer price index (CPI) data for September showed something similar. Both the headline and core CPI surprised to the upside during the month. Consequently, on a year-over-year basis headline CPI slowed while core CPI accelerated. On a more positive note, import prices declined during the month. Taken together, the data paint a picture of stubborn yet shifting inflation. First, services inflation is increasingly constituting more of overall inflation than goods inflation as the supply chain slowly recovers, and consumption patterns shift back toward pre-pandemic norms. Second, excess savings and wage growth are causing an increasing shift from supply-driven inflation to demand-driven inflation. Third, food inflation is driving more of core inflation as energy inflation slows. Despite these shifts, inflation remains highly elevated, demonstrating why no panacea exists to fix this issue quickly or easily.

Relative Spending Slowly Reverting to Pre-Pandemic Norms

Monetary conditions

“Not easy” could also describe the outlook for monetary conditions given such persistent inflation. First and foremost, the Fed will remain aggressive in raising the fed funds rate. Market expectations for the fed funds outlook increased in the wake of last week’s inflation releases, with the futures market now expecting the terminal rate to push near 5% before starting to come down in 2023, more aggressive than the most recent forecast from the Fed.

Many debt instruments that price off of government yields, such as mortgage rates, continue to push higher as well. Third, equity markets remain in bear market territory, reducing the wealth effect. As capital markets continue to shift in the coming months, they will become tighter and less easy, as the Fed attempts to tamp down demand-driven inflation.

The trade off

Of course, heading down this path creates another problem for the Fed we would not categorize as easy: its dual mandate between price stability (i.e., inflation) and full employment. As the Fed raises rates to rein in inflation, it runs the serious risk of creating a recession and causing a significant disruption in the labor market. As we have previously discussed, the Fed sees the labor market as too tight (likely past full employment) and believes that it can cool things down without creating too much trouble. The Fed sees the high number of open jobs relative to the number of unemployed workers as a key metric. It believes that it can remove the excess demand for labor without removing normal demand. But can it? That remains unclear. And we are growing concerned that the Fed is moving so quickly that they might not give higher rates long enough to work before moving on to the next rate hike, which increases the risk they overshoot and cause a recession and major labor market disruption. Most household debt is held in long-term, fixed rate mortgages and many companies capitalized on cheap debt during the last few years, reduced their borrowing cost, and do not immediately face the risk of their debt rolling to higher rates. For those looking for signs of an impact thus far, the housing market is already rolling over and retail sales are coming under pressure from both higher inflation and higher interest rates.

Global situation

Lastly, the global situation beyond the U.S. could also fall under the “not easy” heading. Not only is much of the world also contending with high inflation, as the Fed continues to tighten aggressively, it puts pressure on foreign central banks to also raise rates or to effectively import higher inflation from the U.S. as their currencies depreciate versus the dollar. Some countries can withstand this challenge better than others, especially those not grappling with high inflation. But at a minimum it forces other central banks into decisions made more difficult by the actions of the Fed.

|  What it means for CRE  |

Because of the procyclical nature of commercial real estate (CRE), it risks becoming collateral damage in the battle between inflation and interest rates. Though not immune, demand fundamentals across the asset class have held up relatively well thus far. Any further downsides will depend on the Fed, how far they are willing to push rates, and whether they merely slow the economy or cause a contraction. But the higher the Fed is willing to push rates, especially without waiting to see if previous hikes are having their desired impact, the higher the probability of economic downturn and congruous disruption in the CRE market.

|  Thought of the week  |

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