Fed Raises, Effectively Doubling Down on Credit Tightening

While the main possibilities for action at this meeting boiled down to no raise and raising a quarter point, the Fed opted for the more aggressive move even though tightening was already occurring. Compared to where the thinking was two weeks ago, the decision seems moderate, but much has changed over the last two weeks.

Due to a strong start of the year for consumer spending, a hot labor market that hasn’t slowed as much as desired, and core inflation picking up instead of declining, the Fed had been preparing markets for more rate hikes and what would have been a 50 BPs increase at this meeting.

However, following several recent banking failures and moves by the Fed, U.S. Treasury, FDIC, and other agencies to prevent further failures and ensure ample liquidity in the financial system, financial stability grew to be a greater concern this March, and that shift in focus is already producing tightening beyond what the Fed can do.

Banks and other lenders have been actively tightening credit in response to the crisis of confidence and increased threat of regulatory scrutiny. In other words, we may have already seen a 50 BPs rate increase without the Fed changing any target rate.

With credit conditions tightening due to more conservative behaviors by lenders, consumer and business spending will slow, and growth will cool. That appears to be what is happening in the auto market, but to a relatively small degree so far.

Last year was a year of declining vehicle sales, with demand negatively impacted by increasing auto loan rates that followed the Fed’s moves with a lag. Auto loan rates moved higher by a bit more than 3 full percentage points in 2022.

Auto loan rates have continued to move higher in 2023 despite the Fed having only increased rates by 25 BPs in February. As of the start of this week, the average new auto loan rate is estimated at 8.94%, up 92 BPs from 8.02% in December 2022. The average used auto loan rate increased to 14.01%, up 164 BPs from 12.37% in December.

Auto loan rates have risen despite the Fed moving little and bond yields declining in March because yield spreads have widened to some of the widest levels in at least eight years. The yield spread is a good indicator of a lender’s assessment of risk.

The auto market benefitted from historically narrow spreads in 2021 and into early 2022. Now the reverse is true. This clearly is negative for affordability, which was the key reason that vehicle sales declined in 2022.

The good news is that credit does appear to be flowing. Since consumers seem willing to pay the higher rate, lenders are being compensated for their risk. The auto lending market is wide and diverse, so at present, enough lenders are willing to lend at these rates so that sales do not appear substantially disrupted.

The caveat is that it is tough to judge a month’s performance in the middle of the month when so much volume occurs in the final week and final days of the month. Month-to-date, sales are tracking higher in March than February, but that’s what spring brings to the auto market.

When the month ends, we can quantify the growth and assess the growth against last year, which was not a good year, and against 2019, which was our last normal year. I suspect we will see that spring lifted sales, but not to the extent we normally see. We may beat 2022, but affordability will likely dampen any chance of gaining ground on 2019.

It also doesn’t help consumers that retail used-vehicle prices are likely to begin increasing again, following the gains in wholesale. With both prices and rates rising, any demand momentum will be difficult to maintain. With the Fed raising the Fed Funds Rate again today, lenders are likely to move rates higher still.

Eventually, the rates consumers see will stabilize as the Fed reaches the peak they want and/or risk diminishes, leading to narrower yield spreads. Likewise, once demand cools for a bit, vehicles will return to being depreciating assets. As a result, a would-be buyer who was sidelined looking for a specific payment will eventually see a payment that works for their budget.

We will likely reach that more favorable point for consumers later in the year. For now, the spring doesn’t look very auspicious for stronger vehicle sales.

Jonathan Smoke is the chief economist at Cox Automotive.