Higher interest rates could trickle down to auto demand

Vehicle buyers are likely to feel the Federal Reserve's 0.75-point interest rate increase, analysts from Cox, Moody's and Edmunds agreed.

Dealerships could feel it as well. Edmunds anticipated an impact on both new- and used-vehicle demand, while Moody's predicted interest rates would curtail new-vehicle sales next year.

Moody's Senior Credit Officer Rene Lipsch cited the affordability index his company produces in conjunction with Cox Automotive. The index, which tracks the number of weeks of median household income necessary to buy the average new vehicle, reached an all-time high of 41.3 weeks in May.

"The debate about retail sales is shifting from the question about how quickly vehicle supply can improve to meet pent-up demand to the question about the impact of vehicle pricing and general consumer confidence on demand," Lipsch wrote in an email to Automotive News late last week. He noted the affordability index stood at about 20 percent more than pre-pandemic levels for reasons that include interest rates.

"Yesterday's rate increase could push the index even higher," Lipsch wrote. "For these reasons, we have become more cautious on vehicle demand and lowered our estimate of retail sales in 2023 to [16.3 million] units earlier this week."

Federal Open Market Committee members on June 15 voted to increase the Federal Reserve's federal funds rate target 0.75 point to 1.5 to 1.75 percent as a response to high U.S. inflation.

Cox Automotive chief economist Jonathan Smoke called it the largest increase in nearly 28 years.

Overall, the federal funds rate range is up 1.5 points from June 2021, when the Fed voted to preserve the rate at the same 0 to 0.25 percent it was in April 2021. The Fed projects this range likely will reach 3.4 percent by the end of the year and 3.8 percent in 2023. The central bank's actions have a trickle-down effect upon consumer auto interest rates.

Five days before the Fed decision, the Bureau of Labor Statistics released its latest inflation statistics. The agency said U.S. prices in May were up 1.1 percent from April and 8.6 percent from a year earlier — much higher than the 2 percent annual inflation the Fed seeks.

New-vehicle prices, an agency metric that includes cars, trucks and motorcycles, rose 1 percent from April and 12.6 percent from a year earlier. Used-car and -truck prices in May rose 0.7 percent from April and 16.1 percent from a year earlier.

According to Edmunds, the average new vehicle in May purchased with dealer-arranged loans saw customers committing to pay $656 a month at 5.1 percent interest over 70.5 months. The interest rate was up 0.4 point from April and 0.6 point from a year earlier.

The average used-vehicle loan arranged by a dealership in May carried a $546 monthly payment, an 8.2 percent interest rate and a 70.8-month term, according to Edmunds. That rate was up 0.2 point from April and 0.5 point from May 2021.

Low interest rates have helped consumers buy larger models with more options, particularly in the case of new vehicles, said Jessica Caldwell, Edmunds executive director of insights. She said "until recently, interest rates have been a bit of a cushion" during a time of low inventory, and high demand and prices.

"As Fed rate hikes continue, automakers will find themselves in a bit of a difficult position because lower interest rates will be a costlier marketing incentive at a time when consumers will be more reliant on lower interest rates to combat higher prices," Caldwell said in a statement June 15. "Although the used market has been quicker to reflect these increases, the fact that the new market is now being squeezed with no clear end in sight to supply chain issues means that car shoppers are going to be facing an even more challenging market. Given that auto loan delinquency is expected to rise, now is more important than ever for car shoppers to understand the risks associated with financing more than what they can afford."

Caldwell felt the latest Fed increase would impact both the new and used markets.

"Used will see a more immediate impact as borrowing rates will go up, and although the effect will be less dramatic on new-car APRs due to automakers offering subsidized rates for new buyers, their programs will not be as generous as they once were," she wrote in an email to Automotive News.

But Smoke felt the Fed's action wouldn't cool demand — at least not yet.

"Despite higher rates, we are not seeing a buildup of new-vehicle supply," he wrote. "This may change when production improves substantially, but it has not happened yet and likely won't before next year. As a result, we continue to see new-vehicle price inflation, limited discounting and record-low incentives.

"The Fed's actions will not fix the supply problem, but when production does eventually start to improve, demand may not be able to keep up without a material change in incentives and pricing."

Smoke said 2022 had already seen manufacturers offering fewer special financing deals to consumers, attributing this to the tight supply.

A lack of new inventory would probably keep used-vehicle demand "relatively strong," Smoke said, though he noted that "retail and wholesale used supply have returned to normal, and as a result, used vehicles have returned to being depreciating assets."

The average credit score on new-vehicle loans and leases rose 2 points from a year earlier to 736 during the first quarter, according to Experian. The average used-vehicle credit score increased 6 points to 669.

Smoke said fewer subprime and deep-subprime consumers are buying vehicles, but it's more a function of the budgetary strain they feel from overall U.S. inflation rather than auto interest rates specifically.