Interest Rate Normalization Continues

Today’s rate hike of 25 basis points—bringing the federal funds rate to a target range of 1.25 to 1.50 percent—was supported by sustained GDP expansion and continued strength of the labor market, as well as the highest level of consumer confidence since December 2000. Despite the hurricanes in Texas, Florida and Puerto Rico, the US economy grew at a 3.3 percent annualized pace in the third quarter, which came on the heels of second-quarter acceleration—the quickest half year of growth since 2014. And prior to September’s hurricanes, layoffs and initial jobless claims were hovering near the lowest level since 1973, highlighting underlying strength in the business community.

Given the overall strength of the US economy, this week’s interest rate hike came as no surprise to many. As of late November, futures markets had already priced in a 97 percent chance of a December rate hike, representing a near consensus among investors. The committee itself hints at three additional rate hikes coming in 2018, not all of which are priced into the market at this time—however, even with the expected hikes, interest rates will remain near historically low levels.

The gradual normalization of interest rates is not disrupting the outlook for sustained growth—it’s helping to ensure it. The economy is expected to continue strengthening as the peak of the business cycle approaches.

A robust US economy and growing demand in commercial real estate should offset any dampening effects of higher borrowing costs.

Source: J.P. Morgan Markets, as of December 8, 2017

The Inflation Mystery

Some observers have questioned the outlook for future interest rate hikes due to relatively weak inflation. The Fed’s preferred measure of price pressure, core personal consumption expenditures, has been sluggish in recent months, indicating a year-over-year increase of only 1.4 percent, which falls well short of the central bank’s official 2 percent long-term target. However, many believe that low inflation is transitory, and October’s positive reports on retail sales and the consumer price index indicate that core inflation could be making a comeback. The Fed itself continues to expect inflation to stabilize around that 2 percent target over the medium term, clearing the way for rate hikes next year.

The lack of inflationary pressure has led some analysts to suggest that the Fed should adopt a monetary policy with a lower inflation target. However, monthly inflation figures can be volatile, and numerous factors can affect prices across a broad range of goods. Irregular or undershot inflation should not immediately discredit a policy framework that has successfully supported the recovery for nine years.

Inflation has the potential to impact the timing of future interest rate hikes. But as this week’s action has demonstrated, the Fed is willing to raise rates ahead of on-target inflation, provided that other economic indicators remain firm.

A Consensus Pick for Fed Chair

Pending Senate confirmation, Jerome Powell will become the next Chair of the Federal Reserve when Janet Yellen’s term expires in February. Powell has served as a Fed governor since 2012 and is likely to continue Yellen’s policy of gradual normalization. His nomination has been met by calmness in the markets, a sign that few are expecting a significant shift in policy following the changing of the guard.

Taking the Long View

In our view, commercial real estate investors should plan for steadily rising rates and build a margin into their balance sheets. It’s important to note that as the economy strengthens, businesses will continue to add workers, consumer spending should increase and commercial real estate investors should reap the benefits of a strong economy.

The current climate of soft inflation, steady growth and historically low interest rates should continue to be supportive of the commercial real estate sector for the foreseeable future.