Federal Reserve Observes Economic Slowdown, Potentially Mitigating Effects of Reduced Interest Rates
Historical trends reveal that significant reductions in interest rates during downturns in commercial real estate often precede further dips in prices. The 2001 economic downturn, triggered by decreased business investment spending, did not encompass a broad commercial real estate downturn.
Chad Littell of CoStar Analytics reports on January 3, 2024, at 8:23 PM, that a much-awaited cycle of interest rate reductions might commence as soon as March 2024, according to some Wall Street analysts. Although a decrease in the Federal Reserve's policy rate might be a relief for the commercial real estate sector, historically, asset prices have not always smoothly adjusted to such changes.
The intricacy of cutting interest rates and the underlying reasons for these projected cuts provide insights into potential developments this year.
At its December meeting, the Federal Reserve's policy-making body shifted from its previous "higher-for-longer" approach, entertaining the idea of rate cuts for the first time in years. As Fed Chair Jerome Powell expressed, “Our policy rate is likely at or near its peak for this tightening cycle.”
However, Powell's comments at the December press conference went further, indicating, "Recent indicators suggest that growth of economic activity has slowed significantly from the robust pace seen in the third quarter.”
This observation implies that the Fed is considering factors beyond inflation in its policy rate decisions, with a more thoughtful approach to the economy's trajectory.
Market expectations, as indicated by the CME FedWatch Tool, forecast six 25-basis-point rate reductions next year, targeting a range of 3.75% to 4%. This is a drop of approximately 150 basis points from the current range of 5.25% to 5.5%, surpassing the Federal Open Market Committee's own projections of a mid-to-upper 4% rate by the end of 2024.
Since the 1950s, there have been 17 instances where the Fed lowered its policy rate by over 100 basis points in a short span. Out of these, 13 coincided with a recession. In two cases where rate cuts did not lead to a recession, in the 1960s and 1970s, the policy rate eventually increased significantly within the following 12 to 18 months, exacerbating the interest rate issue.
The other two instances were consecutive rate-cutting periods in the mid-1980s. Different from the previous scenarios, interest rates continued to decrease throughout much of that decade, marked by an average real Gross Domestic Product (GDP) growth of 4.4%.
Today's economic landscape differs significantly from that of the 1980s, particularly in terms of economic growth expectations.
The Congressional Budget Office predicts an average annual real GDP growth of 2% over the next decade, assuming a smooth economic transition. Powell anticipates a cooling in growth for the upcoming year.
Economic growth fuels positive net absorption, or the net change in occupancy. As absorption slows down, along with a consistent influx of new projects in 2024 and 2025, interest rates may lose their dominant influence on commercial real estate prices that they've held in recent years. Instead, the focus for commercial real estate in the near future might shift towards maintaining net income over reducing capital costs.
If Powell’s projections of a cooling economy in the coming year materialize similarly to the early 1990s and late 2000s, vacancy rates may rise alongside continually increasing operating expenses. This scenario could challenge income preservation efforts and often leads to reduced asset valuations.
Source: Chad Littell, CoStar, MMCG