Inflation, the Economy, and Commercial Real Estate
In June and July of this year, the Fed raised the interest rate at the fastest pace in forty years: it raised the federal funds rate 75 basis points at each open market committee meetings. Why did it do so, and what do its actions and current economic data say about the economy? This report will investigate and answer these questions, as well as explore the thinking that is guiding the Fed’s policies and explain the implications of these policies for commercial real estate.
INFLATION AND THE ECONOMY
What is the Federal Funds Rate and what did the Fed do with it in June and July 2022?
The federal funds rate, or fed funds rate, is the rate at which banks1 lend money to each other. By law, banks are required to keep a portion of their customer’s deposits on reserve. To meet this reserve requirement, banks often lend money to each other on a nightly basis. The interest rate banks charge each other when making these loans is the Fed funds rate.
By raising or decreasing the fed funds rate, the Federal Reserve is able to control the supply of available funds, other interest rates (e.g., credit card rates, auto loan rates, mortgage rates, etc.), and, indirectly, inflation. By raising the fed funds rate, borrowing becomes more expensive and that causes the supply of available money to decline, which increases the short-term interest rates and helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term interest rates down.
The Fed raised the federal funds rate by 75 basis points in June and July of this year. A year ago the rate was 0.25%, and now it is 2.50%.
Why did the Fed raise the Fed Funds Rate by so much?
The Fed raised the fed funds rate by so much to control the rising pace of inflation. The Fed uses a variety of measurements to gauge inflation, and as of July, every measure the Fed uses indicated that inflation had risen by an intolerably high rate. For example, year-over-year, inflation rose 9.1% using the consumer price index (CPI) measure of inflation and it rose by 6.8% using the personal consumption expenditure (PCE) measurement of inflation. Even when you remove goods with prices that quickly fluctuate, such as food and energy, from the calculation, also known as core-PCE, inflation has gone up 4.8% year-over-year. You have to go back to 1982 to see yearly increases in inflation this high. By any of these measures, inflation is growing too fast. 2
By law, the Fed is required to pursue policies to achieve maximal sustainable employment and price stability. Accordingly, the Fed has stated that it will increase rates until it sees clear signs that inflation is close to rising only at 2% per year. READ MORE >
COMMERCIAL REAL ESTATE IMPLICATIONS
Given future increases by the Fed and current inflationary conditions, what implications does this have on commercial real estate?
Because commercial real estate is typically viewed as a less volatile asset class, expect capital to move into the sector. Compared to other investment classes, Inflation resistant commercial property types such as hotels, multifamily, self-storage, etc. remain in favor by capital markets.
Although there is upward pressure on interest rates, balance sheet lenders such as banks and credit unions may continue to offer loans with lower borrowing terms than credit market lenders such as CMBS.
Capital markets are also seeking out commercial property types such as industrial and retail which have a built-in rent escalator, or the in-place leases are set to expire in the near future. READ MORE >