Fed Flinches?

A softened response

As expected, the Fed raised rates by 25 basis points (bps), matching the increase from the February meeting and down from the 50-bps increase in December. The Fed has now raised the target fed funds rate nine times since hiking began in March last year. The target rate now ranges from 4.75% to 5.00%, the highest since 2006. The Fed acknowledged that while the banking system remains in overall good health, the disruption of recent weeks will likely tighten credit conditions. In effect, concerns about bank failures are doing the Fed’s job for them, and consequently, the Fed sees less need to hike as aggressively as they likely believed just weeks ago. The Fed statement included a notable dovish turn in language regarding future rate hikes, from “ongoing rate increases” to “some additional policy firming may be appropriate.” The updated forecast shows a terminal rate of 5.1% in 2023, effectively just one more hike of 25 bps. The remainder of the forecast changed little. Despite little change to the forecast itself, that represents a notable deviation from expectations just a few weeks ago when the futures market leaned toward 50 bps. The Fed will continue to reduce its balance sheet holdings as well.

The Fed clearly remains committed to bringing inflation down to its target rate of 2%. Possibly the most important question concerning this now involves timing. No hard and fast rules exist regarding the timeframe to return inflation to target. And as we have noted multiple times, inflation is already falling faster than many people perceive, especially once we exclude housing costs, which have a widely known lag effect on inflation. Given the increased risks to financial stability, and consequently, the labor market, a less aggressive path forward seems warranted, especially with tightening credit conditions. But how patient is the Fed willing to be? How much evidence will it require before it ceases hiking rates? We had expressed concern that the Fed could overshoot and cause a recession before the banking issues emerged. We have increased our level of concern about the downside risks in the wake of increasing financial instability.

In noting the issues surrounding banking, the Fed also recognized that tighter credit conditions would likely weigh on consumers and businesses. We see the impact as a net negative. Beyond credit conditions, the fallout will likely reduce demand in the economy which should marginally slow GDP growth during what was already shaping up as a challenging year characterized by very weak growth. But that reduction in demand should also result in less inflationary pressure than previously anticipated, with inflation now likely easing toward the bottom of our forecast ranges across inflationary indexes. While the banking system appears resilient, especially after implementing the government’s lending program, the exact path forward looks uncertain, with the potential for greater downside risk.

What it means for CRE

Commercial real estate (CRE) was already headed for a slowdown this year. The additional drag on growth should only make for a more challenging environment. This will likely put more downward pressure on rent growth and upward pressure on vacancy rates across property types and markets. Yet given the marginal impact on the economy, we do not view this as a huge problem—just a matter of degree rather than a change in direction. Lower interest rates and a quicker end to tightening could potentially help, but that remains unclear against the backdrop of weakening fundamentals. The market would benefit from the Fed signaling when it plans to end its streak of rate hikes, but we are not there yet.

Thought of the week

The two most valuable companies in the S&P 500 represent more than 13% of the index, a level unseen in roughly four decades.