Pandemic effects and government aid are blunting impact of higher rates, for now
5 min
The world’s central banks raced at an extraordinary pace over the past year to cool inflation, but it hasn’t proved enough—yet.
Economic growth remains mostly solid and price pressures strong across affluent countries despite sharply higher interest rates.
Why haven’t growth and inflation slowed more? Much of the explanation lies in the pandemic’s weird effects and the time it takes for central-bank rate increases to curb economic activity. Additionally, historically tight labor markets have fuelled wage gains and consumer spending.
First, the unusual nature of the pandemic-induced 2020 recession and the ensuing recovery blunted the normal impacts of rate hikes. In 2020 and 2021, the U.S. and other governments provided trillions of dollars in financial assistance to households that were also saving money as the pandemic interrupted normal spending patterns. Meanwhile, central banks’ rock-bottom interest rates allowed companies and consumers to lock in low borrowing costs.
Households and businesses continued to spend heavily in recent months. Families tapped their savings, which were replenished by solid income growth. Businesses kept hiring thanks to pandemic-related labour shortages and large profits.
“There are just a lot of embedded pandemic-era forces that are working against this tightening,” Tom Barkin, president of the Federal Reserve Bank of Richmond, told reporters last week.
Two industries traditionally sensitive to interest rates—autos and construction—offer examples.
Pandemic-related shortages of semiconductor chips limited the supply of cars for sale, leading eager buyers to pay higher prices for the vehicles available. Although U.S. construction of single-family homes tumbled last year, construction employment grew over the past 12 months. Fuelling job growth were supply-chain bottlenecks that extended the time needed to finish homes and a record amount of U.S. apartment construction, which takes longer to complete.
U.S. single-family housing construction has rebounded recently thanks to historically low numbers of homes for sale. Many households refinanced during the pandemic and locked in low mortgage rates—a good reason to stay put. “I didn’t fully anticipate how much the move in interest rates would convince people not to put their houses on the market,” Barkin said.
Normally, the Federal Reserve’s rate increases force heavily indebted consumers and businesses to rein in spending because they have to pay more to service their loans. But consumers haven’t overextended themselves with debt over the past two years; household debt service payments accounted for 9.6% of disposable personal income during the first quarter, below the lowest levels recorded between 1980 and the onset of the pandemic in March 2020.
“A lot of the imbalances you might anticipate at this point in the cycle just have not had the time to build up,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank.
Second, government spending has continued to bolster growth, cushioning economic shocks that proved less catastrophic than expected. While Europe’s energy crisis helped to tip the region into a shallow recession over the winter, the region skirted the deep downturn that some analysts had forecast. European governments pledged up to $850 billion to support spending.
This year falling oil and natural-gas prices have pumped up economic growth by putting money into consumers’ pockets, boosting confidence and easing pressures on government budgets. The price of a barrel of oil has fallen by nearly half in the past year, from around $120 to less than $70—below its level before Russia’s 2022 invasion of Ukraine sent prices soaring.
The reopening of China’s economy supported activity in the country’s many trading partners, while weak domestic growth prompted Beijing this month to provide new stimulus.
In the U.S., fiscal policy has provided more oomph for the economy this year. Federal funding continues to flow from President Biden’s roughly $1 trillion infrastructure package approved in 2021 and two pieces of legislation signed last year that provide hundreds of billions of dollars to boost renewable-energy production and semiconductor manufacturing.
Third, it takes time for higher interest rates to ripple through the economy and cool growth and inflation. The Bank of England first raised interest rates from near zero in December 2021, while the Fed and the European Central Bank lifted off in March 2022 and July 2022, respectively.
By some estimates, the first two-thirds of the Fed’s rate increases only restored rates to a level that was no longer pushing on the gas pedal, while the last third slowed the economy by pressing the brakes. The upshot is that policy has restricted growth for just eight or nine months, Atlanta Fed President Raphael Bostic wrote in an essay published last week.
Chicago Fed President Austan Goolsbee compared the potential coming impact of the Fed’s 5 percentage points in rate increases to the unseen hazards faced by Wile E. Coyote, the unlucky cartoon character. “If you raise 500 basis points in one year, is there a huge rock that’s just floating overhead…that’s going to drop on us?” he said in a recent interview.
Dario Perkins, managing director at the research firm TS Lombard, said higher rates are slowing growth in ways that aren’t obvious, such as by causing employers to cut unfilled jobs or companies to forgo expansion. “It might appear that monetary policy isn’t working when, in fact, it is,” he wrote in a recent report.
To be sure, some central banks might not have done enough to cool demand. The ECB, for example, increased its key rate to 3.5% this month, but it is still negative when adjusted for inflation—potentially a stimulative level.
Many economists still anticipate a recession over the next six to 18 months, either because of past rate increases or those to come.
Just how much higher to raise rates is hard to judge because of mixed signals about economic activity. In the U.S., hiring has been strong, but average hours worked declined in May and the number of people filing for state unemployment benefits has climbed in recent weeks to its highest levels since late 2021.
Falling energy and grocery prices helped lower U.S. inflation to 4% in May from a four-decade high last summer of around 9%, according to the Labor Department’s consumer-price index. The breadth of price increases has narrowed. In May, less than 50% of all prices in the CPI rose by more than 5%, down from 80% of the index at one point last year.
Central bankers remain anxious, however, because measures of so-called core inflation, which exclude volatile food and energy prices, have declined much less. Those readings tend to better predict future inflation.
Central banks in Norway and the U.K. announced half-point interest-rate increases last week to address persistent inflation. Central banks in Canada and Australia recently resumed rate increases after pausing, pointing to higher service-sector inflation and tight labor markets.
The Switzerland-based Bank for International Settlements, a consortium of central banks, warned in a report released Sunday that reducing inflation to many central banks’ 2% target could be harder than expected.
Easy gains from lower energy- and food-price inflation have been banked. The longer high inflation lasts, the more likely it is that people will adjust their behaviour and reinforce it, the BIS said. In that scenario, central banks might find they need to cause a sharper downturn to force inflation down to their goal.
“The ‘last mile’ may pose the biggest challenge,” the BIS said.
Copyright 2020, Dow Jones & Company, Inc. All Rights Reserved Worldwide. LEARN MORE
What a quarter-million dollars gets you in the western capital.
Alexandre de Betak and his wife are focusing on their most personal project yet.
Office-to-residential conversions are gaining traction, helping revitalize depressed business districts
4 min
Developer efforts to convert emptying office towers into residential buildings have largely gone nowhere. That may be finally changing.
The prospect of transforming unused office space into much-needed housing seemed a logical way to resolve both issues. But few conversions moved forward because the cost of acquiring even an aging office building remained too high for the economics to pencil out.
Now that office vacancy has reached record levels, sellers are willing to take what they can. That has caused values to plunge for nothing-special buildings in second-rate locations, making the numbers on many of those properties now viable for conversions.
Seventy-three U.S. conversion projects have been completed this year, slightly up from 63 in 2023, according to real-estate services firm CBRE Group. But another 309 projects are planned or under way with about three-quarters of them office to residential. In all, about 38,000 units are in the works, CBRE said.
“The pipeline keeps replenishing itself,” said Julie Whelan , CBRE’s senior vice president of research.
In the first six months of this year, half of the $1.12 billion in Manhattan office-building purchases were by developers planning conversion projects, according to Ariel Property Advisors.
While New York, Chicago and Washington, D.C., are leading the way, conversions also are popping up in Cincinnati, Phoenix, Houston and Dallas. A venture of General Motors and Bedrock announced Monday a sweeping redevelopment of Detroit’s famed Renaissance Center that includes converting one of its office buildings into apartments and a hotel.
In Cleveland, 12% of its total office inventory is either undergoing conversions or is planned for conversion. Many projects there are clustered around the city’s 10-acre Public Square. The former transit hub went through a $50 million upgrade about 10 years ago, adding fountains, an amphitheater and green paths.
“You end up with so much space that you paid so little for, that you can create amenities that you would never build if you were doing new construction,” said Daniel Neidich, chief executive of Dune Real Estate Partners, a private-equity firm that has teamed up with developer TF Cornerstone to invest $1 billion on about 20 conversion projects throughout the U.S. in the next three years.
Conversions won’t solve the office crisis, or make much of a dent in the U.S. housing shortage . And many obsolete office buildings don’t work as conversion projects because their floors are too big or due to other design issues. The 71 million square feet of conversions that are planned or under way only account for 1.7% of U.S. office inventory, CBRE said.
But city planners believe that conversions will play an important part in revitalising depressed business districts, which have been hollowed out by weak return-to-office rates in many places.
And developers are starting to find ways around longstanding obstacles in larger buildings. A venture led by GFP Real Estate is installing two light wells in a Manhattan office-conversion project at 25 Water St. to ensure that all the apartments will get sufficient light and air.
Cities such as Chicago, Washington, D.C., and Calgary, Alberta, have started to roll out new subsidies, tax breaks and other incentives to boost conversions.
The projects are breathing new life into iconic properties that no longer work as office buildings. The Flatiron Building in New York will be redeveloped into condominiums. In Cincinnati, the owner of the Union Central Life Insurance Building is converting it into more than 280 units of housing with a rooftop pool, health club and commercial space.
In the first couple of years of the pandemic, office building owners were able to hold on to their properties because of government assistance and because tenants continued to pay rent under long-term leases.
As leases matured and demand remained anaemic, landlords began to capitulate and dump buildings at enormous discounts to peak values. In Washington, D.C., for example, Post Brothers last year paid about $66 million for 2100 M Street, which had sold for as much as $150 million in 2007.
Washington, D.C., has been particularly hard hit by the office downturn because the federal government has been especially permissive in allowing employees to work from home .
“We’re able to make it work as a conversion because it was no longer priced as though it could be repositioned as office,” said Matt Pestronk , Post’s president and co-founder.
Increasingly, more deals are taking place behind the scenes as converters reach deals with creditors to buy debt on troubled office buildings and then push out the owners. GFP Real Estate reduced costs of its $240 million conversion of 25 Water Street by buying the debt at a discount and cutting deals with tenants to exit the building before their leases matured.
One of the first projects planned by the venture of Dune and TF Cornerstone likely will be the Wanamaker Building in Philadelphia. TF Cornerstone just purchased the debt on the office space in the building and is in the process of taking title.
“The banks are foreclosing and doing short sales,” said Neidich, Dune’s CEO. “There’s a ton of it going on.”
In Washington, D.C., a conversion of the old Peace Corps headquarters building near Dupont Circle is 70% leased just four months after opening, said developer Gary Cohen . Rents are higher than expected.
“If that’s the way to get people downtown, that’s what we have to do,” Cohen said.
Not all developers agree that the economics of conversions work, even at today’s low prices. Miki Naftali , who has converted more than five New York properties over the years, said he has been very actively looking at conversion candidates but hasn’t yet found a deal that works financially.
One of the issues facing converters is that even if an office building is dying, it often has a few existing tenants who would need to be relocated. Some buildings would need atriums to ensure that all the apartments have sufficient light and air.
“When you start to add everything up, if your costs get close to new construction, that’s when you get to the point that it doesn’t make financial sense,” Naftali said.
Some landlords are including clauses in leases that give them the right to evict tenants to make room for a major conversion. Others are keeping a small ownership stake when they sell buildings so that they can learn the conversion process for future buildings.
“The world is looking at these assets in a different way,” said developer William Rudin , whose company decided to learn the conversion process by keeping a stake in 55 Broad Street, a downtown New York office building it sold last year to a converter.
