Things are getting interesting

Quick takes:

• Inflation surprise
• Fed set to respond
• Domestic momentum slowing
• Global backdrop weakening
• CRE can still perform well

Uh Oh

Last week, the consumer price index (CPI) data for August showed somewhat surprising resilience, exceeding expectations. Though it seemed like inflation would decline slowly and inconsistently, the implications for this resilience lie most with the Fed and monetary policy. As the Fed meets this week, it will take this new data into account. And it comes at a time of slowing economic growth, domestically and globally. What does it all mean?

Consumer > Producer?

Although we received multiple inflation readings last week, everyone focused on the surprise increase in the CPI and disregarded the deceleration in the producer price index (PPI). Both the headline and core CPI surprised on the upside for August. Although that proved sufficient to push the headline reading down on a year-over-year basis versus July, it pushed the core reading up on a year-over-year basis. Food and shelter ranked among the important components continuing to put pressure on overall inflation. The PPI, largely ignored because of the CPI data, came in largely as expected. Consequently, the year-over-year change in the headline reading declined notably versus July while the year-over-year core reading also pulled back. While we have repeatedly warned that inflation would not decline in a linear fashion and that it would prove volatile and slow even as it decelerates. We reiterate that we have likely passed the peak of inflation for this cycle. But that likely provides little comfort to the Fed.

Fed’s Likely Response

This year, the Fed has moved more aggressively as it attempts to tamp down demand-driven inflation. At its last three meetings, it raised the fed funds rate a combined 200 basis points (bps), bringing the target rate to 225-250 bps, right around our estimate of neutral (neither stimulative not contractionary). Since the last Fed meeting in July, as the first signs of slowing CPI emerged, some began to wonder if the Fed might take a less aggressive tack with the fed funds rate over the balance of the year. A debate emerged: would the Fed raise by 50 or 75 bps at its September meeting? Last week’s CPI data almost surely guarantees that the Fed will now raise the fed funds rate by 75 bps, pushing past neutral into slightly contractionary territory.

While the Fed has suggested this might be necessary to slow inflation, it remains an open question as to how far it will go and whether it will tip the economy into recession. We will have more to say about this next week after this week’s meeting, but markets have grown concerned that the Fed will accept a short, shallow recession in the short term that they engineer themselves rather than a longer, deeper recession brought about by intractable inflation and inflation expectations.

Growth already slowing

This battle between inflation and interest rates is playing out against a backdrop of slowing economic growth. Setting aside the GDP data from the first half of the year (which we have addressed in previous Economic Insights), underlying economic momentum is clearly slowing. We knew this would occur after last year’s generational growth, but the pace of slowdown has been quicker than anticipated. Mathematically, GDP growth likely rebounded in the third quarter and grew, but signs of slowing abound. While the labor market remains tight, job growth is slowing, open jobs have pulled back slightly, wage gains have eased in recent months, and the unemployment rate has ticked higher. The for-sale housing market, squarely targeted by higher interest rates, is also showing signs of slowing with almost every major metric for housing health rolling over this year. Even pricing is showing signs of slowing by some, though not all, measures.

Moreover, global growth is also faltering. Higher energy prices, spurred by the war in Eastern Europe and a reduction in energy supply, is pushing some key European economies toward recession. Continuing coronavirus lockdowns are slowing Chinese output at time when its economy grapples with an overheated real estate market and a crackdown on the technology industry. Fiscal policy around the world remains restrained after aggressive spending designed to blunt the impact of the 2020 recession. And most other major central banks around the world are tightening monetary policy as many other countries grapple with uncomfortably high inflation.

|  What it means for CRE  |

For commercial real estate (CRE), all of this clearly means increasing risk, but we do not want to put the cart before the horse. While economic growth is clearly slowing, the underlying dynamics remain supportive of major property types. While that holds, CRE should continue to perform relatively well. But its fortunes will depend upon how much higher rates slow the economy and consequent impact on the drivers of different property types. Yet here there is good news. First, most major property types remain in a favorable position. They can clearly endure some slowing in their underlying drivers unless growth slows too much. Which brings us to the second point – even if (and we stress if) we do end up in a recession, it will likely prove short and shallow, like most post-war recessions induced by higher rates. For now, we retain our cautiously positive stance, but will keep our eyes squarely fixed on the Fed and interest rates.

|  Thought of the week  |

Against a broad array of currencies, the U.S. dollar recently reached its highest level in roughly 20 years.