Earlier this week, the Federal Reserve announced that it will be maintaining its forecast of two more hikes to the U.S. federal interest this year. 

Manufacturers may choose to absorb the higher rates on new vehicles, in order to keep prices from rising higher than they have been with heavier incentives, but this could have an adverse effect on residual values.  

Heavy incentives can hurt residual values by lowering the value of outgoing model years, damaging depreciation curves, and negatively affecting the perceived value of a brand to the public, according to the National Auto Dealers Association.

If a new-vehicle’s price is brought down through heavy incentives, then older model years already in a market will need to have their price dropped, to make them an attractive option to buyers comparing a used car to an incentivized new car.

Additionally, heavily incentivizing new-vehicles reduces the starting point of the outgoing used vehicle, which hurts the depreciation curve for the vehicle, and results in lower prices in the future.

“The price of a vehicle today is very much a function of the price of the same vehicle yesterday, because yesterday’s price is a key reference point for today’s buyers (along with the current prices for similar vehicles),” stated the NADA white paper. “So the legacy of the steep new car discount will continue to be present on a used vehicle as it ages.”

For a more measurable impact, the NADA explained that $1,000 worth of incentives on a new model would reduce the value of a 1-year-old model by $563, and the price of a 3-year-old model by $381. And, the higher the incentives, the bigger impact it has on the price of the older model.

So, $2,000 worth of incentives on a new model would reduce the price of the 1-year-old model by $607, and so forth. The reason for this correlation is that heavier the incentives, the bigger impact they have on shopper behavior.

No federal interest rates were announced for April, however, average interest rates for both new and used vehicles were up for the month. Used vehicle interest rates reached 8.3% in April, rising 1.4% over the same time last year, while new-vehicle interest rates averaged 5.6%, 0.6% higher than the same time last year, according to an Edmunds report.

The current federal interest rate sits at 1.5% to 1.75%. Interest rate hikes are typically carried out at 0.25% increments at a time, so two more interest rate hikes could push the federal interest rate to a range of 2.0% to 2.25% by the end of the year.

While higher interest rate hikes across the board would raise prices for both new and used car segments, the used segment could see a smaller adverse effect, given the fact that the average transaction price for a used vehicle is lower than what it is for a new vehicle.

The average amount financed for a new vehicle in April was $31,318, according to Edmunds. Comparatively, the average amount financed for a used vehicle was $21,620. Should this price difference grow with higher interest rates, buyers looking to get more value out of their dollars may begin to favor used vehicles as opposed to new.

And, prices for new-vehicles have continued to rise. So far this year, every month has seen year-over-year increases to average transaction price for new vehicles. While not entirely due to rising transaction prices, new-vehicle sales have been hurting since last year.

In 2017, overall new-vehicle sales totaled 17.1 million, a 2% decline year-over-year. This marked the first time in seven years that new-vehicle sales didn’t grow year-over-year. Meanwhile, used car sales reached 39.3 million, a 1.8% increase year-over-year during 2017 calendar year.