The Fed Waits, While Warning Signs Flash in the Credit Market

The Fed left interest rates and overall monetary policy unchanged today. We have now had eight straight meetings with no change in rate policy, and this level of restrictive rates has been in place for a full year. The Fed remains focused on achieving a 2% target on core PCE. It was 2.6% in June.

The gap in June compared to target is caused by shelter inflation. Keeping rates at such a restrictive level has dubious chances of making housing cheaper when in fact the problem is mostly caused by insufficient supply. Construction projects do not pencil, so residential construction is declining. Meanwhile, the population continues to grow: Housing stock is not keeping pace.

Waiting is likely not the solution, but the Federal Open Market Committee wants to wait.

Housing is critical to the U.S. economy. Housing impacts vehicle demand as construction pros and contractors make up an important segment for commercial vehicle demand. Consumers who move are also far more likely to buy a new vehicle after changing residences. Fewer people moving means fewer people buying cars.

And indeed, the vehicle market is stuck below potential.

The real Fed Funds Rate, which is the Fed Funds Rate adjusted for inflation, gets more restrictive as inflation falls, while the 23-year high in the policy rate persists. Restrictive rates contribute to the tight and expensive credit environment, which holds back the housing and auto markets’ potential.

However, beyond being a drag on home and vehicle sales, I am growing more worried about consumer credit performance, which indicates something more negative is happening. Interest expense on credit cards appears to be crowding out spending on goods and services and is likely contributing to delinquencies and defaults on credit cards and auto loans.

Since the Fed started raising rates in March 2022, credit card interest rates have skyrocketed to new record highs. According to the Fed, credit card rates have risen from 14.56% in February 2022 to 21.51% in May 2024, their latest data point. That is an increase of 695 basis points, which far exceeds the increase of the Fed Funds Rate.

Over the last two years, consumers grew more reliant on credit cards to keep up with spending and monthly expenses, even as saving rates have declined. Worse, over the last year, the growth in credit balances has been more impacted by the growth in interest expense.

According to the New York Fed’s quarterly report on household debt and credit, credit card balances have risen by $129 billion over the last four available quarters of data through Q1 2024. The most recent balance, if not paid in full, would require $20 billion a month just to cover the interest expense, which is almost double what servicing the interest on the balance would have required in Q1 2022.

While most consumers may be paying their balances in full, it is very likely that an increasing number are not able to pay off the balance and therefore servicing the debt, which in turn is crowding out capacity to spend on actual goods and services or paying other bills. Unlike the Federal Government, there is a limit to what consumers can borrow.

This is a key reason why consumer attitudes, credit performance, and spending are not improving despite relatively strong GDP growth and declining inflation. The consumer was in better shape a year ago, but with each passing month, capacity to spend has been reduced. And waiting only makes this worse.

Without this view of the reliance on expensive credit, it is hard to otherwise explain why auto loan performance remains worrisome in a world with real wage and income gains, low unemployment, and declining inflation. Auto loan delinquency rates remain at record highs for this time of the year, and the default rate for 2024 is now higher than 2019 and getting close to 2010’s elevated rate.

Consumers prioritize their auto debt in the U.S., as we Americans are very dependent on private transportation. Lose your vehicle and you lose mobility and potentially your livelihood. Yet with a “strong economy,” defaults are on track to be their worst since the Great Recession. That is not a good sign.

Keeping rates at this restrictive level too long is a risky strategy. The good news is that if credit card rates follow the Fed’s rate cuts as quickly as they followed their increases, that debt service will decline rapidly once the Fed starts cutting. That would be a tailwind for consumers.

However, I am not encouraged by today’s decision to wait being the 17^th straight unanimous decision by the Fed. There should be more debate, as the economics community is divided on this topic. In my opinion, we are risking the economy over a questionable target based on an imprecise and imperfect measure of inflation. My worry is that conditions will deteriorate more at an accelerating pace before the Fed finally decides to cut.

For consumers waiting on lower rates to buy a new vehicle, relief is not right around the corner. It is doubtful that auto rates will rapidly decline as soon as the Fed starts cutting. With auto loan performance shaky, auto loan rates are bound to be sticky on the way down. That means that the Fed waiting compounds the wait for consumers.

The average new auto loan interest rate in July was 9.72%, up over 50 BPs year over year but down from a peak of 10% in early June. The average used auto loan rate peaked in February at 14.6% and is currently off its peak at 14.2% but up nearly 60 BPs year over year.

Once the Fed Funds Rate is headed for neutral, the average rate on new auto loans is likely to end up between 7.5% and 8%. Given what the Fed communicated today, it is not likely that auto loan rates will decline much before year’s end and, unfortunately, the auto market will remain stuck below potential.

Jonathan Smoke

Chief Economist

Jonathan Smoke leads Cox Automotive’s economic and industry insights team, which tracks key metrics and trends impacting both the wholesale and retail markets for vehicles informed by the proprietary data from the company’s businesses and platforms. For 28 years, Smoke has focused on translating data and trends into relevant actionable insights for the industries that represent the biggest purchases that consumers make in their lifetimes: real estate and automotive. Smoke joined Cox Automotive in 2017.