Dissecting how inflation could ripple into automotive space

CARY, N.C. - 

Cox Automotive senior economist Charlie Chesbrough explained the challenge facing the Federal Open Market Committee (FOMC) at the Federal Reserve. Chesbrough articulated how the implications might not impact dealership turns and finance company originations immediately, but he cautioned that trends can be difficult to steer if momentum builds too much.

That challenge revolves around inflation and how much Fed policymakers might accelerate interest rate increases. During a conference call at the beginning of February, Chesbrough pointed out that the federal funds rate has risen by 75 basis points in the past year.

“That’s a real cost for consumers out there in the marketplace, not only for their automotive loans but for interest rates they have to pay on credit cards, home loans and everything else out there,” Chesbrough said. “The expectation is that although the economy is strong, those interest rates are going to continue to rise throughout the course of the year.

“In fact, the recent passage of tax reform may force the economy to grow a little bit more quickly than what’s expected, which may force the Fed to raise interest rates a little more quickly than expected,” he continued.

“Those higher interest rates are going to have a higher impact on vehicle sales. Whether it’s enough to stop the vehicle market, I think that’s probably a stretch. But we do expect it to be a growing headwind throughout the course of the year,” Chesbrough went on to say.

At least thus far, any impact from interest rates on vehicle sales has been largely muted judging by what the Fed shared from its automotive contacts for its first Beige Book of 2018. The rundown from the 12 Federal Reserve Districts indicated that the economy continued to expand from late November through the end of the year. More than half of the districts specifically noted auto activity, including:

—Bank of Cleveland: The report said, “Year-to-date unit sales through November of new motor vehicles rose 3 percent compared to those of a year ago. One dealer commented that interest rate changes have not yet made an impact on new-car transactions.”

—Bank of Atlanta: The report noted, “District retail contacts reported an uptick in sales levels since the last report. Merchants noted that early holiday sales activity was above expectations. According to automobile dealers in the district, however, momentum of auto sales slowed compared with year-earlier levels.”

—Bank of Chicago: The repor t mentioned, “New light-vehicle sales in the District were flat in spite of generous incentives. Used vehicle sales were also flat. Dealers expected new light vehicle sales in 2018 to be about the same as in 2017.”

—Bank of St. Louis: According to Beige Book: “Reports from auto dealers were mixed: While multiple auto dealers from Louisville and Little Rock reported improved traffic and sales, Memphis auto dealers reported that sales have softened the past two months. Auto dealers throughout the District hold an optimistic outlook for 2018.”

—Bank of Kansas City: The report found, “Auto sales fell moderately since the previous survey but were above year-ago levels. Dealer contacts anticipated a moderate pickup in sales in the months ahead, and auto inventories were expected to remain stable.”

—Bank of Dallas: The report indicated: “The auto industry remained very strong, with a notable pickup in auto sales after a lull in the prior reporting period.”

—Bank of San Francisco: The report added, “Vehicle dealers reported strong in-store traffic and sales, as activity rebounded from the previous months.”

Soon after the Fed released its first of eight installments of Beige Book on tap of 2018, policymakers distributed their statement on longer-run goals and monetary policy strategy. FOMC members reiterated that they are firmly committed to fulfilling their statutory mandate from Congress of promoting maximum employment, stable prices and moderate long-term interest rates.

In setting monetary policy, the committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the committee’s assessments of its maximum level,” the members said. “These objectives are generally complementary.

“However, under circumstances in which the committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate,” they continued.

Chesbrough picked up on what the Fed stated and looked to interpret the strategy while explaining how it could impact the auto space as dealers look to keep inventory churning and finance companies try to maintain prudent origination growth.

“If you historically where we’re at, it does appear on the charts visually that we’re on the cusp of something happening with inflation,” Chesbrough continued. “We’ve been in such a low inflationary environment for such a long time now that it’s become the expectation if inflation is coming, probably on the backs of rising wages from the tight labor market, that’s almost what everyone is hoping for; that workers are able to start asking for higher wages, employers have to give those to keep those workers and then the costs are passed on to consumers. That launches the inflationary environment. That’s what’s the expectation is, and I think there is a lot of evidence to suggest that’s where we’re at.

“The big question is can the Federal Reserve manage this environment? That’s where the real danger is. Can there be a policy mistake? Can the Fed raise interest rates too quickly and choke off consumer spending and send us into a recession? And I’m not suggesting any kind of 2008-2009 kind of recession, more of a mild downturn in the market. But that’s the question. Or if they go too slowly, inflation may get out of hand and then that can be very difficult to get back in the bottle. Once inflation starts taking off, everybody wants to see their wages go up, and it’s a tax on everyone because your spending power goes down,” he went on to say.

Perhaps complicating the situation even further is federal tax reform that’s set to potentially send more money into consumers’ pockets, which could provide more leeway for prospective buyers to stretch to make monthly payments.

Despite any moderate snags, Cox Automotive is seeing that tax cuts should enhance new-vehicle sales this year. In fact, the analyst team raised its sales forecast by 100,000 units to 16.7 million.

“Certainly the expectation is that consumers are going to see more money in their take-home pay because the withholding rates have been changed from the IRS because it’s a lower tax bracket,” Chesbrough said. “We should see some noticeable improvement at least individually that they should see they have more money than they would normally. The theory is that’s a very good plus for the economy because people will have more spending money.

“On the whole, I think it’s going to be positive for economic growth,” he added. “Whether it’s going to be a home run for everybody, we still don’t know that yet.”

So in closing, Chesbrough described a generally upbeat economy and automotive industry, especially for the remainder of the year. However, he acknowledged that there are some “headwinds,” especially when it comes to inflation possibly triggering interest rate changes.

“It does appear we’re entering an inflationary environment, but that’s not to say it’s coming right away. It might take a while for inflation to creep up,” he said.

“I still think we’ve still got a good year or two before we see inflation hit any kind of a level to be a real threat to the U.S. economy,” Chesbrough concluded.