Liberty Street Economics

« | Main | »

November 23, 2015

End of the Road? Impact of Interest Rate Changes on the Automobile Market

LSE_2015_interest-rate-impact-on-autos_copeland_460_art

The Federal Reserve has kept interest rates at historic lows for the last six years, but eventually rates will return to their long-term averages. That means both policymakers and the public will once again be asking one of the classic questions in monetary economics: What are the impacts of rising interest rates on the real economy? Our recent New York Fed staff report “Interest Rates and the Market for New Light Vehicles,” considers this question for the U.S. market for new cars and light trucks. We find strong evidence that rising rates will dampen activity: Our model predicts that in the short-run a 100-basis-point increase in interest rates will cause light vehicle production to fall at an annual rate of 12 percent and sales to fall at an annual rate of 3.25 percent.

Background

Economic theory predicts that the durable goods market is a key channel through which monetary policy affects the real economy. Interest rate changes affect this market through two channels.

  1. Household expenditure channel

    Higher interest rates raise the cost of borrowing for households, inducing a decline in demand for automobiles (see this Liberty Street Economics blog post for more about households’ financing of automobiles). Hence, sales and real prices should fall. Automakers will react to the decline in demand by curtailing production and their inventories may rise or fall, depending on the size of the sales decline relative to the decline in production.

  2. Firm inventory channel

    Higher interest rates raise the cost of holding inventories for automakers, inducing them to economize on inventories by reducing production and by cutting real prices to raise sales. The overall impact on sales, however, isn’t clear cut. The reason is that reducing inventories dampens sales, whereas cutting prices increases sales.

The overall effect of increasing interest rates for both households and automakers, then, is ambiguous for sales and inventories. Indeed, this reasoning may explain why previous research has found little effect of real interest rates on sales and inventories in durable goods markets.

Our Approach

To capture the various ways interest rates affect the sales, real prices, production, and inventories of automobiles, we construct a dynamic market model that embeds the two channels described above. An innovation of our approach is that households and automakers face separate interest rates. This is both consistent with what we observe in practice and also enables us to disentangle the effects of the household expenditure and the firm inventory channels.

We estimate our model using high-quality data on automobiles from 1972 to 2011 and demonstrate that the model fits the data well. We then use the model to predict what happens to sales, real prices, and production when interest rates rise.

The Results

We begin by simulating a scenario in which the households’ interest rate rises 100 basis points unexpectedly, then slowly reverts back to its long-term equilibrium value. The model simulation enables us to track how the growth rates of sales, real prices, and production deviate from their long-term equilibrium values.

This exercise highlights the impact of rate changes through the household expenditure channel. The set of graphs below illustrates the model’s predictions: The dotted lines are the steady-state values of the variables, and the solid lines are the deviations from that value, given a 100-basis-point shock. The model predicts that the annual growth rate of sales immediately falls to -0.5 percent and slowly moves back to its steady-state value over eight months. In reaction to the rise in households’ interest rates, automakers anticipate the fall in demand and dramatically cut prices and production in the short run.

Impulse Response to a 100-Basis-Point Shock to Households’ Interest Rates

We then repeat this exercise, but this time consider an unexpected 100-basis-point increase to automakers’ interest rates to highlight the impact of rate changes through the firm inventory channel. The graphs below illustrate the model’s predictions; we have kept the scales fixed from the previous set of graphs, so as to provide for easier comparison. In response to the higher rates, which increase the costs of holding inventories, automakers look to shed their inventories. They accomplish this with both a small price decrease, which leads to a short burst of sales, and a small decrease in production (see the pull-out in the production growth graph).

The price impact is small, but its effect on sales is boosted by the dynamic nature of a household’s problem. Households recognize that automakers are decreasing real-price growth in the first month following the interest rate shock and then increasing prices in the second month (see the pull-out in the real-prices growth graph), leading households to shift their new auto purchases from future periods to the current period. Indeed, sales growth falls sharply in the second month.

impulse-response-to-a-100-basis-point-shock-to-automakers-interest-rate

Looking across the two sets of impulse-response graphs, we see that the 100-basis-point increase in households’ interest rates has a much bigger impact on real-price and output growth than the similarly sized shock to automakers’ interest rates.

As a final exercise, we then increase both households’ and automakers’ interest rates by 100 basis points—the scenario that would occur under monetary policy tightening. The responses of households and automakers to common interest rate increases reinforce one another along some dimensions, while offsetting each other along others. As illustrated in the set of graphs below, this shock leads to large temporary declines in the growth rates of real prices and output.

Production falls by an annualized rate of 12 percent in the month immediately following the shock, which translates into a decline of 170,000 automobiles. The offsetting effects of the household expenditure and firm inventory channels mean that sales growth is initially close to its steady-state value, before falling at an annualized rate of 3.25 percent in the second month after the shock to interest rates and then slowly recovering back to the steady-state value.

Impulse Response to a 100-Basis-Point Shock to Both Households’ and Automakers’ Interest Rates

Overall, we find evidence that interest rate changes have marked effects on sales and production in the automobile market, through both the household expenditure and firm inventory channels. Further, a 100-basis-point increase in households’ interest rates has a much bigger impact on real-price and production growth than the similarly sized shock to automakers’ interest rates.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.


Copeland_adam
Adam Copeland is a research officer in the Federal Reserve Bank of New York’s Research and Statistics Group.

George Hall is the Fred C. Hecht Professor in Economics and Chair of the Department of Economics at Brandeis University.

Louis J.Maccini is Professor Emeritus in the Department of Economics at Johns Hopkins University.

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

Thank you for your comments and suggestions. Regarding the graphs, the growth rates of sales, production, and real prices return to their steady-state values in the long-run. For ease of viewing we cut off the charts at 20 months, before these variables had a chance to return to their steady state.

As a non-economist, it is unfortunate that economists use the term “impulse response” when the more apt engineering term here would be “step response.” Even in finance, one has a step up in basis. If I read the graphs correctly, your long run steady state results, e.g., showing increased production, are counter-intuitive. Is this so? I assume this was motivated by an expected federal funds rate hike in December. Unless this also includes directly engineering a hike in other loan rates, I think an impulse response study to a federal funds rate hike on auto loan and mortgage rates would be useful.

Lower inventory leads to lower price for automobiles and that leads to lower inflation and so that would appear to be counter productive

The comments to this entry are closed.

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Image of NYFED Economic Research Tracker Icon Liberty Street Economics is available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Economic Inequality

image of inequality icons for the Economic Inequality: A Research Series

This ongoing Liberty Street Economics series analyzes disparities in economic and policy outcomes by race, gender, age, region, income, and other factors.

Most Read this Year

Comment Guidelines

 

We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1,500 characters.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be relevant: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post.

Please be respectful: We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will
not be posted.‎

Comments with links: Please do not include any links in your comment, even if you feel the links will contribute to the discussion. Comments with links will not be posted.

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.

Archives