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Mixed messages

The Fed indicated it will begin to reduce the size of its balance sheet next month. If the Fed adheres to the guidelines that it published in June, balance sheet normalization will last for three to four years. At its conclusion, the Fed will likely remain with a balance sheet between $2.5 trillion and $3.0 trillion. Though down from the roughly $4.5 trillion we have today, that will remain well above the $800 billion on the books before the Great Recession. We believe that maintaining a larger balance sheet is appropriate for a variety of reasons, including the potential for increased financial stability, easier execution of monetary policy, and increased liquidity (especially during a crisis). The Fed could further unwind its balance sheet, but that would require a longer period of time based on current guidelines.

What impact will this unwinding have on interest rates? We continue to believe that this program will slowly put upward pressure on interest rates at the long end of the yield curve. As the Fed sells assets this will put downward pressure on their prices and upward pressure on yields, all things being equal. We estimate the total impact of this could be roughly 40 to 50 basis points, assuming a $1.5 to $2.0 trillion reduction in assets over a three- to four-year period.

Short-term surprise

But what about yields at the short end of the curve? The Fed’s statement reiterated its intention to hike rates for a third time this year. This caught many off guard. The surprise does not stem from the Fed’s statements or forecasts for 2017. Those have not changed. The surprise stems from the Fed’s intention to be “data driven” which essentially means the Fed is in the process of achieving its dual mandate of full employment (estimated to be in the 4-4.5 percent range) and price stability (the Fed’s inflation rate target of 2 percent). Full employment has largely been achieved. Price stability has not. Inflation remains inexplicably low, below the Fed’s target rate. Even Fed Chair Yellen took pains to explain why inflation has been stubbornly low. Many members of the Fed continue to believe that transitory factors are behind weak inflation. But core inflation, which is less volatile than headline inflation, continues to trend downward and the Fed itself has revised its forecast for core inflation downward. 

So how does that outlook square with another rate hike in December? One could reasonably argue that based on the inflation data alone there was a stronger case for a rate hike earlier in the year, not later. The answer lies in the outlook – only if one believes that core inflation is being held back by temporary factors and that rebound lurks ahead would someone argue for another hike in 2017 within the Fed's data-driven framework. We anticipate that core inflation will slowly increase over time, but we still question the likelihood of one more hike in 2017. As we have repeatedly stated we do not believe that any single 25-basis-point hike would have much impact on the economy or inflation yet. Interest rates remain below the neutral level (the rate at which the economy is neither stimulated nor depressed) so another hike will have little to no impact. That is not the issue. The issue is that based on the Fed's own data dependency guidelines, a third rate hike seemed unlikely and reversing course confused just about everyone as evidenced by the abrupt shift in the fed funds futures market.

What role does fiscal policy play?

Fiscal policy remains the wild card in all of this. Congress failed once again to enact healthcare reform. The issue could arise in the future, but for now reform efforts have reached a dead end. Tax reform on the other hand appears to be gathering momentum. The administration and Congress would both like to see changes such as a simpler tax code and lower tax rates: they should find more agreement than they did on healthcare reform. But tax reform is not a slam dunk. Unresolved issues, such as passing a budget for 2018 and how much revenue loss is acceptable, will need to be resolved before any legislation proceeds.

We believe that any reform package will be modest, partially because there will be no savings from healthcare reform before tax reform begins. We expect a combination of tax cuts and possibly some minor simplification of the tax code. A major overhaul seems unlikely. We believe that there is only about a 50 percent chance of tax reform passing in 2017, but even if it does not occur there is a relatively high probability of something passing in 2018. The impact on the economy would be modest, likely 30-50 basis points above 2017 GDP growth.  But the prospect for faster growth fueling inflation could be factored into the outlook of Fed governors and could be a key reason why the Fed at least states they foresee a third rate hike this year.

What does it all mean for CRE?

What should the real estate market make of this? In the short run, not much. 

Even if the Fed hikes rates in December, there will be little impact on the real estate market.

In the long run, we continue to expect rates to drift higher across the yield curve, driven by the Fed gradually raising at the short end and its normalization at the long end. As rates move higher over time, the cost of debt capital will increase, making some deals unworkable, or at least change the capital structure of deals. The real risk is that eventually rates push past the neutral rate, causing a slowdown in the economy which would impact commercial real estate fundamentals. 

Slowing (and eventually contracting) rent growth coupled with a slowdown in vacancy compression (and then vacancy expansion) would impact construction pipelines, valuations, and cap rates. But that will likely take a few years to fully unfold.

For now, we still see little interest-rate induced pressure on valuations and cap rates. Hotel cap rates are moving higher, but that process began before interest rate increases and is due to sector-specific factors such as the construction pipeline, perceived threat of AirBnB, etc. Transaction volume has been declining this year, but that is due to the widening rift in pricing expectations between buyers and sellers at this late stage of an economic expansion.

What else happened last week?             

Housing starts and permits exhibited continued upward momentum in August. The one exception was in multifamily starts.

Both lenders and investors appear to be more cautious about the multifamily sector after more than seven-and-a-half years of expansion in that sector.

Existing home sales for August declined, due at least in part to the impact of Hurricane Harvey. The data for new and existing homes is likely to remain distorted for at least another quarter or two due to the Harvey and Irma. Initial unemployment claims remained elevated, also due to the impact of the hurricanes.

What we are watching this week

The third estimate of second quarter GDP should show a modest upward revision due to construction spending and inventory growth. Personal income and spending for August should both show very slight increases. New home sales for August should see little change, although the impact from the hurricanes could show up. Durable goods orders for August should see a slight rebound from July, due to somewhat weaker business investment. Lastly, both consumer confidence and consumer sentiment for September should remain at elevated levels, even if either dips slightly. The tight labor market should prop up consumer spirits despite any impact from the hurricanes.

Thought of the week

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