Since early 2021, the topic of interest rates has dominated headlines and conversations in the financial world, especially when it comes to real estate. Questions like “should the Federal Reserve raise interest rates?” and “should they lower rates or keep rates the same?” are asked almost daily on networks like CNBC and Bloomberg. This kind of speculation occurs anytime there is economic uncertainty, but there is something unique about the situation we find ourselves in today. In the past, the raising and lowering of interest rates, which is actually the Overnight Lending rate or “Fed Funds” rate, was seen as a solution to a problem – the Federal Reserve, or “The Fed,” would lower rates to stimulate economic activity and they would raise rates to encourage saving and investment. Due to some questionable decision-making, we now find ourselves in a much more dangerous scenario – one in which it does not matter if The Fed decides to raise, lower or hold rates the same. There is going to be severe economic turbulence no matter The Feds decision; in fact, the only decision we really have is whether we would prefer inflation or a recession – a rock or a hard place.
Inflation – The Rock
The over-arching problem The Fed has been trying to solve since early 2021 has been inflation, and the solution so far has been higher interest rates. Here is how it works: when The Fed raises rates, it makes it more difficult for consumers to borrow money for big purchases like cars and houses, and more difficult for businesses to borrow to fuel expansion and growth. The higher rates increase yields from savings accounts, making businesses and consumers more likely to keep their money in the bank, helping reduce asset prices and bring the rate of inflation back on its ideal trajectory of 2% year-over-year. To this point, the strategy has been moderately successful, with the Consumer Price Index, or CPI, having gone from 9.1% in June of 2022 to 3.2% as of February 2024. But has the strategy really yielded the intended results? To answer that, we must dig into the data.
The Data
The first goal of “rate hikes” is to slow consumer spending, but consumer credit card debt is currently at an all-time high of $1.053 TRILLION DOLLARS – over $200 billion dollars higher since January 1st 2020. Additionally, household debt reached an all-time high of $17.5 Trillion in Q4 of 2023. Coupling this information with the jobs data and low unemployment rate reveals a troubling trend of people working more hours, in many cases for multiple jobs, yet spending more money on credit – a clear indication that inflation is still a major problem for the average American, who is struggling to make ends meet and is using credit to bridge the gap. Inflation is the supply of money AND credit in an economy, not just money.
Consumer Loans: Credit Cards and Other Revolving Plans, All Commercial Banks. (2024, March). FRED Economic Data. https://fred.stlouisfed.org/series/CCLACBW027SBOG
The second goal of rate hikes is to slow corporate spending, but corporate debt is also hovering just below an all-time high at $13.6 trillion dollars, as corporations are continuing to borrow money. That is a signal that The Fed needs to make monetary policy more restrictive by RAISING rates, not less restrictive by lowering them. Finally, rate hikes should be increasing the Personal Saving Rate, which sits near it’s all-time low at 3.6% as of February 2024 – a far cry from the 7.2% in January, 2020. Consumers are spending almost every dollar they earn, yet are still reliant on credit to pay their bills – this is an unsustainable solution.
Personal Saving Rate. (2024, March). FRED Economic Data. ttps://fred.stlouisfed.org/series/PSAVERT
In essence, The Fed has done just enough to bring the headline numbers down significantly, but they have not done enough to fundamentally solve the problem. If they were to lower rates as currently planned, asset prices would rise significantly in the short term and the CPI would likely exceed the high-water mark of 9.1% it achieved post-pandemic – and could rise much higher from there.
Recession – The Hard Place
Given the data, one may think The Fed has an easy decision to make: hold or raise rates so as to not experience the wrath of inflation, an economic condition that has destroyed many great civilizations. Of course, that decision would not be met without consequences of its own – most notably, a recession.
Easy Money In the aftermath of the Great Financial Crisis in ‘07-’08, The Federal Reserve lowered rates to essentially 0% from December of 2008 to December of 2015, and then again from April of 2020 to January of 2022 as a reaction to the pandemic. As a result, many businesses and individuals in that period were able to borrow money at a rate they were not necessarily qualified for.
Federal Funds Effective Rate. (2024, March). FRED Economic Data. https://fred.stlouisfed.org/series/FEDFUNDS#
When rates are low, lending institutions are enabled to lend out more money to more speculative borrowers, increasing the likelihood of defaults. Over time, these institutions and businesses become reliant on this “easy money” – their decisions and business models are developed around the idea that they will be able to borrow money at a particular rate of interest. Any increase in that interest rate will lead to increased costs, making it less likely for those businesses to succeed and those institutions to get their money back. That can be an issue when rates have already lowered to 0%.
The Bubble
The above scenario has created an “asset bubble,” an environment in which prices for goods like real estate, stocks, cars, etc., become much greater than their fundamental values would support, which is a byproduct of the “easy money” policies over the past 20 years. That bubble was pricked when The Fed began raising rates in early 2022, but they have been able to avoid any capitulation to this point. However, the higher interest rates go and the longer they are held, the more likely we are to start seeing major cost-saving efforts in the form of layoffs, “rightsizing,” and bankruptcies. Already this year, Google, UPS, Sony, Nike, Ford and Meta have all announced significant layoffs, just to name a few. These companies were encouraged to expand their businesses and hire new employees because of the low borrowing costs. As those costs have risen dramatically, these companies have been forced to pull-back on their plans for growth and are now focused on consolidation in order to reduce costs. The growing list of companies is also an indication that these problems are not limited to one sector; rather, it is a broad-based problem across all industries.
If interest rates are held at their current range longer than markets anticipate, or in the event rates are raised higher, more air is going to come out of the asset bubble, leading to more layoffs and defaults, pushing our economy into recession. With interest rates now in a range that is normal by historical standards, a recession may be considered a necessary evil.
Wrap Up
It may not be a decision we want to be faced with, but the choices are certainly clear: The Federal Reserve can lower rates to reignite a struggling economy, or they can hold or raise rates to extinguish the inflation fire once and for all. As a commercial real estate investor, all you can do is prepare yourself with information and react accordingly. While these headwinds present problems in the short term, they will also create major opportunities in the CRE market for many years to come. If you’re interested in learning more or would like to discuss your commercial real estate investment, contact me at (440)-708-8578 or Noah.Broadbent@naipvc.com.