The U.S. economy continues to adjust to the effects of the tightening of monetary policy started by the Federal Reserve in March 2022 and the disruptions to the supply chain begun by the pandemic in March 2020. The net effect of that process has been a slowing pace of aggregate economic activity, which has been strongly felt in the construction industry.
The principal source of uncertainty facing both the policy makers and all economic actors is whether the economy will go into recession in 2024.
Two elements are likely to decide that issue. The first is when and how and why the Federal Open Market Committee (FOMC) calls a halt to the rise in the target Federal Funds Rate. The second is whether any further disruptions to the supply chain occur.
The current rise in the Federal Funds Rate is the result of two decisions by the FOMC. The first, which has largely gone unnoticed, was their desire to move away from the Zero Interest strategy that was first put in place during the recession of 2007-2009. The second, which is the more widely known, was their mission to restore price stability following the outbreak of inflation.
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While it was felt that the exigent circumstances that surfaced as the economy contracted warranted the extreme measure of setting the base interest rate at zero, by late 2015, the FOMC began to raise the target rate in order to bring conditions in the fixed-income market back to more traditional levels.
That effort started in December of 2015 with the Federal Funds Rate at averaging 0.24% and ended in July of 2019 when the Funds Rate averaged 2.40%. At that point the FOMC, reacting to a softening of economic activity, began lowering the Funds target such that it stood at a 1.58% average for February 2020, which is when the pandemic began.
In order to help contain the economic effects of the lockdown, the FOMC immediately cut the Funds Rate target to zero and kept it there until March 2022.
Since that time, the FOMC has raised the Federal Funds Target at each of its regular meetings, save that of June 2023, by at least one quarter of a percent. And while the announcements of each of those increases focused on the FOMC’s efforts to combat inflation, the other reason for the increases is to bring about the restoration of a more traditionally shaped yield curve.
Our reason for bringing this up is decisions the FOMC will have to make about when to stop raising interest rates will be immediately followed by the decisions they will need to make as to when and where to stop cutting interest rates. Because we think they do not intend to go back to the zero limit, barring exigent circumstances, it is important to consider what the lower boundary of the yield curve will be going forward.
Most importantly, activity in the construction sector is interest-rate sensitive and how much conditions might improve following the end of the interest rate rise will largely depend on how far and how fast interest rates fall. We don’t expect them to fall as far as they did last time the FOMC reversed policy.
In the immediate term, the FOMC’s action on rates will largely be determined by the news on the inflation front. Federal Reserve Chair Jerome Powell has stated most emphatically the Fed intends to pursue a policy that will bring us back to the conditions where their preferred measure of inflation — the Personal Consumption Expenditure Price Index excluding Food and Energy (Core PCE) has gone back to 2%. It is currently more than 3%.
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The Core PCE is computed by the Bureau of Economic Analysis as part of the Gross Domestic Product statistics. It is reported late in the month. The FOMC prefers this measure over its statistical cousin the Consumer Price Index excluding Food and Energy (Core CPI), which is computed by the Bureau of Labor Statistics and reported early in the month because the Core PCE better reflects the current mix of consumer spending.
The reason we bring up all this operational detail is because Chair Powell is a stickler for protocol. As a result, policy changes are going to happen as the data becomes available and as that availability squares up with the FOMC’s meeting schedule. The FOMC will move very deliberately, despite what you might read in the business press.
How quickly the Core PCE gets back to the FOMC’s 2% target is going to depend on how its component parts behave.
There is no such thing as a Core PCE. Rather, that measure is the weighted sum of the changes in the prices that make up the index. One of the principal components of the Core PCE are the measures associated with the cost of shelter. There are three main elements here. Cash rents, which is what is collected by landlords, operating costs, such as utilities, which are paid by both renters and homeowners and Owners’ Equivalent Rent of Primary Residence (OERPR), which is an estimate of what the value of service provided by the residence is to the owner. Of the three, OERPR is the largest.
The payment made by a homeowner for principal, interest, taxes and insurance forms the basis for OERPR. Each payment is case specific based on the price of the home, the terms of the mortgage and the property tax assessment. Over time, OERPR rises and falls based on how those elements rise and fall. The key point, however, is that OERPR does not make sudden moves.
Currently, the shelter components of the Core PCE are running well above the 2% target. So, it will not be surprising if the FOMC is forced to hold the Federal Funds Rate target at, or near, its terminal point, until such time as it feels that the improvement it is seeing in the Core PCE is well founded and lasting.
Which brings us to the major source of the inflation the FOMC is trying to contain — the supply chain.
Both the statistical and anecdotal evidence suggest the worst of the supply chain problems are behind us. While there are still some problems, the conditions that enabled large increases in prices have dissipated. Pricing power has begun to swing back towards buyers.
The final aspect of the outlook for construction activity relates to the structural changes that have taken place in the demand for real estate.
On the commercial side there are two major trends in play.
The first, on the plus side, is the reshoring of manufacturing activity and the increased need for material handling facilities. This trend is expected to last for several years.
The second, on the negative side, is the decreased demand for both office and retail space as a result of changes wrought by the pandemic.
Anecdotal evidence suggests the demand for office space is not going to return to the levels it had prior to the pandemic. Most firms are still not able to bring their workforce back to the office five days a week. As a result, it is expected the current softness in office demand will become a permanent event.
On the retail side, conditions are equally unbalanced and the anecdotal evidence is mixed. But the overall outlook is for less demand.
In the residential market there also are two trends.
In the single-family sector, we have the usual depressing effects of high interest rates on affordability. This should abate as rates recede.
In multi-family, we are currently at a record high for units under construction, which will maintain activity despite the level of rates.
Taken together, all of these elements suggest the next year will be quite challenging for the construction sector of the economy.
There is no immediate prospect of significant relief on either the availability of credit or its cost.
Furthermore, the specter of a full-fledged recession continues to loom until such time as the FOMC begins to ease the restraints brought about by its current policy.
