Friday’s non-farm payroll report in the US provided an “all clear” for the Federal Reserve to undertake the first rate hike since 2006.
October’s job gains were the highest seen in the US since January 2015, and were significant enough to bring the unemployment rate down to 5%. But the labour market picture has been improving for some time, so what makes us certain the Fed will hike at its December meeting?
Both Fed chairman Janet Yellen and president William Dudley have indicated that a rate hike in December is a “live possibility”. Three other reasons to expect a policy move are as follows:
• Wages are rising. Average hourly earnings climbed by 2.5% year-on-year – the largest annual gain since 2009 – while measures of slack are decidedly improved. The fraction of employees working part-time because of economic reasons has fallen from a cycle high of 33% to 21%, while the median duration of unemployment has declined from 25.2 to 11.2 weeks. Wage growth (or the lack thereof) has been the missing piece in the unemployment rate decline puzzle. However, if the recent payroll report is any indication, wages across all job categories are increasing. Even in the lowest-paid sectors – leisure/hospitality and retail trade – wage growth has been 2.5% or more over the past 12 months. And with zero headline inflation for September, real wage growth of 2.5% is meaningful. Inflation is likely to stabilise.
• Heading into the new year, the drag on inflation from low oil prices is likely to dissipate. In September, spot oil prices averaged $45.45 (£30) a barrel, versus $93.22 in September 2014, making for a 51% decline. In January, spot prices averaged $47.27, close to the $45-$46 average in October and November. Will a stronger dollar continue to weigh on non-energy import prices? Yes. Even though the core PCE (personal consumption expenditure) price index has not exceeded 1.3% on an annual basis this year, services price inflation (which has been at 1.8% or higher all year) will likely put a floor on any further energy-based declines.
• Foreign financial markets have stabilised. Gone was the phrase “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term” from the Fed’s last statement. Domestic equity markets are at record highs. China’s stock index is back in “bull market” territory as the country’s Securities Regulatory Commission has just announced that a freeze in initial public offerings will end by the close of this year, suggesting markets have stabilised. The Fed cannot ignore activity abroad, but domestic growth appears strong enough to begin the process of rate normalisation in 2015, even if the Fed stands firm during the first half of 2016.
So what does this mean for commercial real estate? Policy action by the Fed will be one of the most widely anticipated moves of all time, so any increase in inter-bank lending rates should come as no surprise to the markets. The extent of any pass-through to longer-term Treasury rates is a little more in doubt.
Longer-term rates today should be equivalent to current and future short rates, plus a liquidity and term premium. Already, interest rates have moved up in anticipation of a rate hike, with 10-year US Treasury bond yields moving from just under 2% to over 2.3% in less than one month.
Does this mean that borrowing costs will necessarily increase for developers and other commercial real estate investors? Much will depend on the extent to which any increase in yields is used as a buying opportunity by overseas investors hoping to take advantage of higher yields alongside any potential US dollar appreciation, although foreign central banks and sovereign wealth funds may continue to pare assets.
Similarly, appetite for additional commercial real estate lending by banks will play an important role, as will demand for securitised debt from CMBS investors.
However, it is likely that the Fed will embark on a cycle of rate tightening slowly, as indicated by this phrase that has repeatedly appeared in its policy statements: “Economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”
Higher interest rates, at least over the next year, are unlikely to derail commercial real estate markets.
Heidi Learner is chief economist at Savills Studley
