The Fed Strikes – Friday Market Insight – NGKF

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39 - Fed Strikes

 

The Federal Reserve finally got out of the starting gate on Wednesday, raising the federal funds rate (the rate charged for overnight loans between banks) for the first time in nearly a decade, by a quarter of a percentage point to a range of 0.25% to 0.50%. This ended an unprecedented seven-year period of near-zero interest rates following the recession and financial crisis of 2008-2009. In economic projections that accompanied its announcement, the Fed has penciled in four quarter-point increases in each of the next three years, pushing the rate to its equilibrium level of 3.5% by the end of 2018. This would be about half the pace of the last tightening cycle from 2004 to 2006, when the rate rose from 1.00% to 5.25% in 17 quarter-point increments.

 

The bottom line is that monetary policy remains accommodative, and the pace of tightening will be slow. For real estate, this marks the likely end of cap rate compression and portends a gradual rise in interest rates on mortgage and construction loans, eventually putting upward pressure on cap rates. The planned slow pace of tightening will help CRE acclimate to this turning point in the cycle. Strong fundamentals will push rents and NOIs higher, as the economy continues to expand, mitigating the impact that rising cap rates will have on property values.

 

However, the upward pressure on cap rates may not start for a while, and when it does, it will come in fits and starts. There is clearly not a close correlation between the federal funds rate and cap rates, as shown in the adjacent graph. During the 2004-2006 tightening cycle, when the federal funds rate rose sharply, the average cap rate for all property types actually fell by about a percentage point, and the spread between the cap rate and the 10-year Treasury yield compressed from 295 basis points to 158 basis points, as investors poured increasingly large amounts of capital into the property markets.

 

The Fed’s announcement, no doubt the most widely telegraphed and dissected monetary policy change in Fed history, should be considered good news. It means the Fed believes that the economy is finally fit enough to absorb higher rates, and that core inflation (which excludes food and energy) will rise from its current rate of 1.3% to the Fed’s target rate of 2.0%, despite disinflationary forces in the eurozone and Japan. In other words, the Fed is confident the U.S. is strong enough to weather turmoil including the oil and commodity bust, the weak manufacturing sector, and slowing growth in China.

 

Bob Bach

Director of Research – Americas

312.224.3244 

rbach@ngkf.com 

500 W Monroe Street, Suite 2900

Chicago, IL 60661

 

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