How the Car Market Is Shedding Light on a Key Inflation Question

In a recent speech titled “Taking Inflation Down,” Federal Reserve Vice Chairman Lyle Brainard pointed to the auto market as a real-world example of a major uncertainty hanging over the outlook for rising prices: What will happen next to corporate profits.

Many companies have been able to raise prices beyond their rising costs over the past two years, boosting profitability but also exacerbating inflation. This is especially true for the automotive market. While dealerships pay manufacturers more for inventory, they charge customers even higher prices, sending their profits to record high values.

Dealers could pull this off because demand is strong and amid disruptions in parts supply, there are too few trucks and sedans to go around. But — in line with its desire for the economy as a whole — the Fed hopes both sides of that equation are on the verge of change.

“With production ramping up and interest-sensitive demand cooling, there may soon be downward pressure on vehicle margins and prices to move the higher volume of cars being produced off dealer lots,” explained Mr. Ms. Brainard during her remarks.

The Federal Reserve is raising interest rates to make borrowing for big purchases — cars, houses, business expansions — more expensive. The aim is to cool demand and slow the fastest inflation in four decades. Whether it can achieve this without inflicting serious pain on the economy will depend in part on how easily companies give up their huge profits.

If companies start cutting prices to compete for customers as demand declines, price increases can be slowed without costing many jobs. But if they try to hold on to big gains, the transition could be more bumpy as the Fed is forced to squeeze the economy more dramatically and reduce demand more severely.

“There’s a huge shift in bargaining power between consumers and corporates,” said Gennady Goldberg, senior U.S. interest rate strategist at TD Securities. “This is where the next correction has to come – corporates have to see some pain.”

The example of the automobile industry gives reasons for hope, but also for caution. While there are signs that used-car price increases are starting to slow as supply recovers, that process is stalling and the new-car market illustrates why the road to lower profits that help slow inflation could be a long one.

That’s because three major forces at work in the broader economy are particularly evident in the auto market. Supply chains are not fully healed. Search may be slowing, but there’s still momentum. And companies accustomed to charging high prices and earning big profits are hesitant to give up.

The car market has split into two segments that are now distinct – new cars and used cars.

New car production has been turned upside down as the pandemic shut down factories making semiconductors and other parts, and it’s only limping back. Freshly built vehicles remain extremely scarce, according to dealers and data, and several industry experts said they don’t see a return to normal production levels for years as supply problems persist. the prices are still growing rapidlyand dealer profits remain sharply elevated with little sign of cracking.

In contrast, used car supply has rebounded since the pandemic slump, as have prices began to depreciate at the wholesale level where dealers buy their stock. But for now, these dealers aren’t actually passing those savings on to consumers. The price of a typical used car has stabilized about $28,000, up 9 percent from a year ago, based on data from Cox Automotive. Official used car inflation data weakens, but very slightly.

Why consumer used car prices – and dealer profits – take so long to moderate is something of a mystery. Jonathan Smoak, chief economist at Cox Automotive, said dealers may be basing their prices on what they paid earlier in the year, when costs were higher, for the cars sitting on their lots.

“Dealers are feeling it,” Mr. Smoke said of the price moderation. “But because they price their vehicles based on what they pay for them, the consumer still doesn’t see the price discounts.”

Some early cases of discounting are emerging. IN Buick and GMC dealership that Beth Weaver operated in Erie, Pennsylvania, demand for used cars began to decline and the business sold several vehicles at a loss.

“There are still patterns that we’ve been able to be profitable from – nothing like last year,” Ms Weaver said.

Behavior like Ms. Weaver’s can escalate. Still, the road to falling used car prices can be bumpy. Ms Weaver said she wouldn’t have to cut prices as much if she cast a wider net – she only sells locally and doesn’t deliver cars as a business model – but urban areas and parts of the South are seeing demand pick up. holds better.

Some dealers believe there is still unsatisfied demand for used vehicles after several years in which families have struggled to find cars. They also doubt supply will roar back since 2020 and 2021 produced so few cars. This gives them the confidence and ability to avoid making too many concessions.

“We price our vehicles almost every day based on market dynamics,” said Bill Feinstein, who helps manage Honda dealerships selling new and used cars in New Jersey and New Hampshire. “Demand remains strong and the consumer still appears relatively intact.”

But dealers and industry analysts agreed that higher Fed interest rates could help change that.

The central bank is raising borrowing costs at the fastest clip since 1980 and a third straight move of three-quarters of a percentage point is expected on Wednesday. As it becomes more expensive to finance a car purchase, price-sensitive car buyers in the used car market may begin to withdraw more significantly, forcing used car dealers to charge less.

New cars may be a different story, however, as supply and demand remain so extreme.

Mr. Feinstein’s Honda dealership in New Jersey typically sells 50 to 100 new cars. That’s an improvement from the peak of the pandemic shortage, when sometimes only five or six were available, but nothing compared to the 1,000-car inventory it would have had before the pandemic. Meanwhile, customers continue to be desperate for new vehicles.

“Everything shows that the consumer has been able to bear the rate hikes for now,” Mr. Feinstein said.

John Murphy, an equity analyst at Bank of America who studies the auto industry, said the imbalance between supply and demand for new vehicles could continue into 2024 due to ongoing parts and labor shortages and movable locks in China.

The Federal Reserve could raise interest rates enough to quell demand, but given how much pent-up appetite there is for buying cars, Mr Murphy thinks it will take a lot.

“You’re probably going to have to go further with rates than they have been or even expected to go,” he said. “There may be a point where you’re in enough pain to see a pause on demand.”

If demand continues to outpace the supply of new cars and dealers continue to reap big profits, that could limit how quickly inflation eases. If the discrepancy is large enough that sellers can continue to raise prices without losing customers, it may even continue to fuel inflation.

Although the auto market is just one industry, the uncertainty about its return to normal holds several lessons for the Fed. On the one hand, new car production makes it clear that supply chain disruptions are improving but not disappearing.

More reliably, the auto industry can offer evidence that the laws of economics are likely to reassert themselves eventually. At least used car prices have stopped rising as inventory has risen and experts say a cut is likely around the corner. If that happens, it could be evidence that companies won’t be able to sustain high prices and profits indefinitely once supply catches up with demand.

But the cars are raising the prospect that the readjustment period could go on for some time.

Automakers are flirting with the idea of ​​keeping production lower so there are fewer cars on the market and price cuts are less common. Mr. Smoke is skeptical that they will stick to that line since it means giving up market share to competitors — but the process could take months or years.

“I hesitate to say we won’t have a discount anymore,” Mr. Smoke said. “But it will take a while to get back to that world.”