Pushing harder

Quick takes:

• Fed hikes as expected
• Signals higher peak rate coming
• Also recognizes lag in economic impact
• Inflation remains key
• CRE remains full of opportunity

Events and data from last week show that the Fed will venture further into restrictive territory as it aims to cool the economy and inflation. The labor market, one of the Fed’s key areas of interest, remains tight and will likely give the Fed cover to keep increasing rates. But the Fed’s actions also caused further yield curve inversion, a potentially worrying sign.

First, the Fed

As expected, the Fed raised rates by another 75 basis points (bps). That represented the fourth consecutive hike of that magnitude, following March’s 50 bps hike. It brought the target rate to a range of 3.75% to 4.00%, the highest since December 2007. It also represents the fastest pace of hiking ever, reaching 400 bps (at the high end of the target range) in roughly a third of the time it took during the 2004-2006 cycle. Chair Powell finally acknowledged one of our key concerns, the lag between raising rates and the impact on economic activity. He also signaled that interest rates will likely have to reach even higher, but that the pace of increases could slow in future meetings. While we are happy that the Fed finally acknowledged our concern, we would also note that we are already seeing signs that policy changes are impacting the economy. Some of the most interest-rate sensitive parts of the economy, such as housing, construction and manufacturing, are already showing evidence of slowing. It seems only a matter of time before that slowdown spills over into other components of the economy. 

Actions plus messaging finally pushed a key part of the yield curve into inversion. The 3-month/10-year spread, widely regarded as the most important and accurate part of the yield curve for its predictive powers, finally inverted with the 3-month rate rising above the 10-year rate. For now, it has not inverted long enough to represent a meaningful signal of trouble, but it will warrant closer watching now. If it remains inverted, economic trouble could lurk 6-18 months down the road. And some other key recessionary signals remain mixed, indicating a recession is not a foregone conclusion. The possibility of a soft landing still exists, but it is getting harder and harder to envision and the Fed pushes farther into restrictive territory.

Focus on inflation

Inflation is playing the biggest role in the Fed’s decisions. But the question of when it will more meaningfully decelerate remains unanswered. Next year seems the most likely time. It tentatively seems like some components of inflation are finally rolling over. Commodities like energy have already peaked and declined. Goods inflation also seems to have peaked and has begun to recede. But services inflation continues to increase, and consumers revert to some semblance of pre-pandemic norms and shift more of their spending away from goods towards services. Services spending will likely take a bit of time to peak before backing off.

This week we will receive data from the consumer price index (CPI) for October. We expect headline CPI to get a lift from energy price increases during the month (even though the overall trend in downward). Core CPI should see support from services (as noted above). Ultimately, we expect the year-over-year change in headline CPI to decelerate slightly while the core CPI holds steady. That should provide the Fed with enough evidence to hike again when they meet in December.

Strength in labor

One other key factor in inflation, the labor market, continued to show strength in the most recent data and tentatively hints at slowing. While the number of open jobs surprisingly increased in September and new job gains for October grew by more than anticipated, a general slowdown in the labor market remains evident. Net job gains continue to gradually slow over time as the economy slows under pressure from higher inflation and higher interest rates. The unemployment rate increased slightly during October as the labor force participation rate slowed down. And even though average hourly earnings continued to increase at a brisk pace, the year-over-year change continues to slow. After peaking at 5.6% in March, October showed this rate falling back to 4.7%, the first time it has fallen below 5% since last December. Slowing wage growth should also help inflation slowdown in the coming quarters.

Decelerating Wage Growth

|  What it means for CRE  |

Commercial real estate (CRE) remains a procyclical asset class so the economy will have much to say about its performance. But as we noted last week, challenges also present opportunities. Expanding on this topic, each of the major property types will face its own set of unique challenges and opportunities. While most everyone recognizes the challenges associated with timing and shape of return to office, almost nobody ever discusses the tremendous opportunities for whoever correctly solves that puzzle. Even if demand for goods slows with the overall economy, the structural changes in consumption patterns still present opportunities for industrial. Relatedly, the evolution of retail continues. Over the last two decades, those that have understood this evolution and not run away from it have experienced great success. And the apartment market continues to serve a vital role in the economy as demand for housing increases and supply, outside of certain pockets, fails to keep pace. Market participants who are proactively thinking about these issues now should set themselves up well for the next phase of the cycle. 

|  Thought of the week  |

In addition to rate hikes, the Fed is effectively reducing its balance sheet by $95 billion of Treasury bonds and mortgage securities every month.