Last week, the Fed did something that it had not done since 1994: It raised the fed funds rate by 75 basis points.

Leading up to the announcement, the Fed reiterated that it intended to raise this rate by 50 basis points. The Fed stated that it changed its approach to address high, persistent inflation. Ultimately, that claim seems substantiated. But more directly, it appears that the Fed changed its mind because markets signaled that the Fed was not doing enough to control inflation.

Equity markets fell into bear market territory and fixed income yields pushed higher as bond prices declined. The Fed won’t admit so, but it seems that the markets forced the Fed into doing something that it otherwise wouldn’t have done, even with May’s upside inflation surprise.

The Fed also raised the terminal fed funds rate in its forecast by 100 basis points to 3.8%, well past our estimate of r-star (neutral) at about 2.5%, with the Fed taking a harder stance that more squarely pits interest rates against inflation. Both sides of that battle carry risks, which might prove asymmetrical.

Inflation leads

Let’s take inflation first. Empirical research dating back decades proves that inflation upsets consumers (overall) more than other economic phenomena, including high unemployment and job losses.

But we do not need to reach into the distant past for evidence of this. In early June, consumer sentiment reached its lowest level on record. Yet, empirical research also demonstrates that unless inflation reaches very high levels, it tends to have a negligible cost and impact on economic growth. Our own humble contribution to this research reaffirms this position.

That raises the obvious question: “Why is the Fed so concerned with inflation?” There seems little chance of inflation rising to a high-enough level to impair economic growth. But concerns about inflation, especially outsized ones like we observe now, could influence behavior in a way that negatively impacts the economy. If consumers believe that inflation will cause economic trouble in the future (i.e. a recession), they might alter their behaviors in anticipation of such an outcome, and in the process bring about a self-fulfilling prophecy.

While that risk is likely increasing, it remains far from certain that it would manifest. In the absence of such an outcome, risk of higher inflation on economic growth remains incredibly limited.

Interest rates follow

What about the other side of this battle? Higher interest rates attempt to reduce inflation by impacting the demand side of the economy. Because central banks like the Fed can exert little or no direct control over the supply side of the economy, they raise rates to increase the cost of borrowing, negatively impacting the prospects for interest-rate-sensitive industries such as housing, financial services and durable goods.

As those industries experience lower revenues and slower job growth (if not outright job losses), growth in the economy starts to slow as those businesses and their employees (or former employees) spend less.

That helps to bring demand and supply back into balance. But the risk here is much clearer. If the Fed raises rates too much, the probability of a recession increases significantly because the decline in spending spirals into further job losses in other industries and an even greater reduction in overall spending. Most post-war recessions in the U.S. occurred because the Fed overshot interest rates.

Can the Fed actually reduce inflation?

Against such a backdrop, it might seem foolish for the Fed to start pushing even harder on interest rates. Many have noted such risks since last week’s Fed meeting. But another key question remains unanswered: Can the Fed actually reduce inflation? And here the evidence also seems suspect.

During the last four tightening cycles dating back to the 1990s, the data appears to show limited efficacy. Using the Fed’s preferred inflation measure, the core (excluding food and energy) personal consumption expenditures (PCE) index, monthly inflation did not trend downward during periods of Fed tightening. The monthly data appear somewhat random, and not indicative of deceleration brought about by higher rates.

Moreover, in the current environment, inflation is increasingly driven by food and energy, partially because of war in Europe and partially because of lack of capacity in energy production and refining. The Fed exerts almost no control over these. Therefore, the Fed is targeting what it can – the labor market.

The Fed sees excess demand for labor (most clearly in the 11.4 million open jobs) and believes it is contributing to the inflation problem. Even though wage growth and core inflation have both decelerated in recent months, the Fed seems willing to weaken the labor market to attempt to reduce headline inflation. The Fed would likely accept a higher unemployment rate, slower job gains and even job losses to tamp down inflation.

Yet that path tends to be a slippery slope to recession. To be fair, on multiple occasions the Fed has successfully managed to slow the economy and bring down inflation without causing a recession. It does not receive enough credit for this. But the course that the Fed charted last week could lead to a troublesome destination if it is not careful.

Lookout! Errr … outlook

The upshot? The 75-basis points increase by itself does not mean much. Rates remain low. But the forecast for the fed funds rate creates greater concern. If the Fed follows through, it will almost certainly push past the neutral rate into contractionary territory. How long the economy could sustain such rates without a recession remains murky. And the Fed does not need to adhere to its own forecast.

For those looking for a silver lining, the Fed has a terrible track record of following through on its own forecasts. If the Fed went too far, the Treasury market would likely signal so, much as it did during the last business cycle. That could prevent the Fed from hiking too much.

For now, our base case shows moderate growth for the economy, driven by a strong labor market and robust consumer spending. But the Fed’s increasingly hawkish interest rate forecast is raising recession risk.

What it means for CRE

Commercial real estate is digesting all the changes from recent months, including last week’s Fed decision and forecast. The market has not yet lost faith, but because things are changing so quickly, market participants are taking an extra beat or two to ensure that they are not making a mistake.

Interest remains high, but the rapidly changing environment requires extra homework. Borrowers, lenders, buyers, sellers, landlords and tenants are all assessing rapidly changing conditions, trying to avoid making a costly error. Participants are weighing longer-term confidence in the asset class against short-term uncertainty.

Ryan Severino is chief economist with JLL.

After a tumultuous two years, commercial real estate market conditions still haven’t stabilized. The COVID-19 pandemic has entered a less urgent phase, but now the public and private sectors are contending with its repercussions, including the end of stimulus programs.

During its quarterly survey of brokers from its independently owned member firms, CORFAC found that overall business sentiment in member markets remains encouraging, even as concerns emerge about the effects of inflation and rising interest rates on potential deals.

“CORFAC members are seeing strong deal activity even as we continue to contend with political and economic unknowns,” said 2022 CORFAC president Mason L. Capitani, SIOR, principal of L. Mason Capitani/CORFAC International in Detroit, Michigan. “Our quarterly survey shows that our brokers have a unique perspective on how macro trends affect their markets and can use that to help their clients make better future-looking decisions.”

Where deal activity is coming from

Looking at where CORFAC business is growing, the largest source of new business this year is existing clients who are expanding, according to 70% of members surveyed – an increase from 63% the previous year. Clients relocating to the market was the next highest source of new business at nearly 50%. Investor interest in secondary markets where price pressure isn’t as great, including those across the Midwest, is creating opportunity for CRE brokers.

Industrial continues to be the strongest CRE subsector for CORFAC members with 65% of respondents saying it drove business activity. CORFAC brokers are also seeing new activity from specialized niches of retail and office, such as medical offices and quick-serve restaurants in retail, while big-box retail and large office buildings are being readapted as logistics spaces.

“While residential migration to outer markets has slowed, industrial interest in secondary markets is very strong,” said Hayim Mizrachi, CCIM, president of MDL Group/CORFAC International in Las Vegas, Nevada. “There is pent-up demand for this product.”

The impact of work and commerce changes

Shifting consumer behaviors in the 2020s ­– particularly the growth of work from home and digital commerce, as well as the great job migration – will shape CRE trends for the near future. Specifically, 62% of members believe office will be the CRE sector that changes the most in 2022, as companies are still adjusting to the growth of remote and hybrid workforces. However, some members point to huge multinational corporations such as Google bringing back employees to the office as a reason for optimism.

CORFAC brokers were asked what their greatest concerns are looking at current events and macroeconomic trends. More than 55% of members identified inflation and rising interest rates as the factor that will have the most negative effect on CRE transaction activity. Continued supply chain challenges and the constrained labor market are compounding those rising costs to cause uncertainty in the CRE marketplace.

As one member summed it up, “Consumer spending has been strong through the last 12 months as we thought we were rebounding from the global pandemic and all the related implications, but now with inflation rising and consumer spending reduced, the economy will slow and have rippling effects on all sectors.”

Strong sentiment in the face of concerns

Despite these worries, half of CORFAC members describe overall business sentiment in their market as “somewhat positive” and another third say it’s “very positive.” The strength of the industrial subsector and readily available capital are common reasons for this positivity. Yet, other members are hoping for some changes in government leadership, tax policy or both to help buoy businesses and CRE activity.

As business owners try to understand how economic policies will impact their real estate plans, CORFAC brokers will draw from local experience and global network insights to help them make confident decisions.

CORFAC International is a network of independently owned commercial real estate firms. CORFAC has 70 offices across the globe.

First there was COVID. Then came the uncertainty of when, or if, employees would return to the office. Now comes inflation and rising interest rates. No wonder the office market remains in limbo across the United States.

JLL recently released its second quarter office outlook and, in little surprise, it shows an office market that is still struggling to regain its momentum following the pandemic while facing an uncertain economy.

According to the report, office transactions remained largely flat in the second quarter. JLL reported that gross leasing activity totaled 47.2 million square feet in the quarter, an increase of just 0.1% from the first quarter of the year. The reason for the sluggish activity level? Tenants, both large and small, have put their expansion plans on hold as they wait to see the impact of inflation and rising interest rates.

The U.S. office sector is still lagging when compared to the months before the pandemic. JLL says that second quarter leasing activity in the U.S. office market is now at 75.5% of its pre-pandemic norms.

Despite economic uncertainty, nearly half of all completed office leases in the second quarter came in at 10 years or longer, keeping the average lease term at eight years. Short-term expansions remained below 20% of all office lease activity, JLL reported.

Net absorption remained negative in the U.S. office market in the second quarter, with 7.8 million square feet of net occupancy loss during the most recent three months. A majority of the quarter’s negative net absorption — 69.4% — came in the Class-B and Class-C sectors.

Combined with 11.8 million square feet of new office deliveries in the quarter, this negative net absorption led to a 30-basis point rise in vacancy to a new high of 18.9% across the United States. The office vacancy rate stood at 16.5% for buildings delivered since 2015 and 19% for older properties.

Even in the down market, developers are bringing new office space to the U.S. market. According to JLL, that 11.8 million square feet of new office space delivered between April and June brought year-to-date completions to 26.5 million square feet. That puts the U.S. office market on track to repeat 2021’s more than 50 million square feet of new office space.