Another Challenge for the Fed to Contend With

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Equities closed out the week on a high note, with the major indices posting strong gains on Friday and positive returns for the full week. Bonds also rallied as yields fell in response to April's jobs report that showed weaker than expected job growth and slowing wage data. The surge on Friday capped a volatile week that highlighted just how focused the markets are on inflation threats and the timing of rate cuts from the Federal Reserve. Consider that earlier in the week markets sold off after the Bureau of Labor Statistics’ Employment Cost Index (ECI) showed labor costs rose 1.2 percent during the first quarter, above Wall Street estimates of 1 percent and the fastest pace since March 2023. On a year-over-year basis, the report showed compensation costs were up 4.2 percent. While outsized market reactions to wage and jobs data is nothing new since the Fed first began raising rates two years ago, the discrepancy between two measures highlights how quickly the inflation needle can move when the economy is late in the business cycle.

Both the ECI and Nonfarm payroll data measure payroll costs, but they are calculated differently and cover different time frames. While these discrepancies make apples to apples comparisons impossible, they can be useful in identifying changes in trends and what may be behind those changes. For example, late last year, conventional wisdom held that inflation was sustainably on the path to two percent, and the Fed might begin cutting rates as early as March of this year. As optimism moved higher, financial conditions became looser, and consumers concluded rates were going to fall and continued to head to the stores as a result. Unfortunately, the upbeat take and looser financial conditions may have contributed to inflation ticking back up and wage growth accelerating. Evidence of this is the ECI report showing compensation costs rose by 1.2 percent during the first quarter, up 0.3 percent from the fourth quarter of 2024 and the highest reading since March 2023. Fast-forward to the latter part of the first quarter of this year. Concerns about price pressures returned, and optimism among consumers and business about the size and timing of rate cuts faded. Perhaps not coincidently, the April Nonfarm payroll report showed average hourly earnings grew at 0.2 percent, the same pace as the previous month and below Wall Street expectations. On a year-over-year basis, wages were up 3.9 percent.  

Certainly, we’re not suggesting that inflation expectations are the primary cause for wage growth; however, we believe that the impact of every factor that goes into rising prices carries a greater impact late in the business cycle, when the economy is producing above its long-term growth capacity and resources are stretched thin. In the early days of a growth cycle, there is more slack, or cushion, to absorb temporary inflationary pressures. However, when the labor market is tight and production is at its limit, things that earlier in the business cycle may have created a small ripple in inflation can have an outsized impact.

This reality adds to the Federal Reserve’s already daunting task of trying to bring inflation down to its target while not pushing the economy into contraction. As we discussed in a commentary in January, consumer expectations are a double-edged sword. Consumers spend less and workers are willing to tolerate slower growth in wages when they believe the economy is heading in the wrong direction. As the Fed makes progress on the inflation front, consumers and businesses turn more optimistic, and spending and wage gains may accelerate—which threatens the Fed’s effort to bring inflation sustainably down to its 2 percent target.

As such, we continue to believe that despite the Fed’s best efforts to the contrary, it is unlikely the Fed will be able to avoid a mild recession as it continues to battle stubborn price pressures even if the employment picture shows additional signs of softening.

Wall Street wrap

More on the Jobs report: The Nonfarm payrolls report for April showed that employers added 175,000 new positions for the month, down from 315,000 in March and below Wall Street estimates. It’s worth noting, however, that revisions to the February and March readings resulted in a net reduction of 22,000 positions in the total number of jobs added for the two months combined. Conversely, the Bureau of Labor Statistics (BLS) other jobs report, the Household survey, showed the unemployment rate rising to 3.9 percent from last month’s level of 3.8 percent.

The lighter than expected job gains and slower pace of wage growth in the Nonfarm data led some investors to speculate the Fed may have room for two rate cuts during the second half of this year. We remain skeptical given signs in various surveys, including last week's Purchasing Manager’s Index (PMI) reports from the Institute for Supply Management (ISM) that show price pressures continue to climb for businesses.

Job openings decline modestly: The BLS Job Openings and Labor Turnover Survey released last week showed the number of job openings in March came in at 8.5 million, down from 8.8 million in February and well below the series high of 12.2 million in March of 2022. The so-called “quits” rate, which is viewed as a proxy for the level of confidence employees feel about the job market, declined modestly to 2.1 percent from the prior month's level of 2.2 percent.

Manufacturing prices jump as sector contracts: The latest data from the ISM shows prices in the manufacturing sector continued to climb even as activity slipped back into contraction territory. The latest headline reading of 49.2 resumes a 16-month trend of contractionary readings that was interrupted by March’s reading, which showed modest growth. The April level is down 1.1 points to 49.2. A reading of 50 or above signals expansion. Readings for new orders came in at 49.1, down 2.3 points from March. Order backlogs remain in contraction territory, with the April reading declining to 45.4—down from March’s 46.3 level.

Despite weakening in the manufacturing industry, materials prices continued to increase, with the latest reading coming in at 60.9, up from 55.8 percent in March and the sharpest increase since June 2022. In total, 13 of the 18 industries in the survey reported paying higher prices. The latest reading marks the fourth consecutive month of rising prices, suggesting that inflation pressures may continue to be at risk of reigniting and broadening within the goods side of the economy. Goods prices have been the driving force in the disinflationary process as price increases shifted to the services sector. With input prices continuing to climb, we may see inflation on this side of the economy perk up, which could put additional upward pressure on inflation overall.

The employment index rose 1.2 points in April from the prior month but remains in contraction at 48.6.

Growth in the services sector continues to ease: Meanwhile, ISM data for the services side of the economy showed that the sector slipped into contraction in April, with a headline reading for the sector coming in at 49.4, down from 51.4 in March. New orders continued to ease, dropping to 52.2 from March’s reading of 54.4. Along with contracting growth, demand for workers declined further, with the employment index coming in at 45.9, down from March’s reading of 48.5. The latest employment index reading marks the fourth time in the past five months that both ISM’s manufacturing and services employment surveys have been in contractionary territory. Reflecting the oddity of the post-COVID economic period, it’s unusual to see contraction like this without seeing actual job losses. Prior to the onset of COVID in early 2020, if you go back to the start of monthly ISM services data in 1997, both services and manufacturing showed contraction (below 50) in 44 months. In all but three of those months there were private-sector job losses.

On the inflation front, the prices paid index in the survey jumped to 59.2, up 5.8 points from a level of 53.4. The number of industries that reported paying higher prices ticked up to 14 of 18.

The declining employment readings and rising prices for the two sides of the economy bear monitoring, as they could complicate the Fed’s decision-making on interest rates should they signal a rise in unemployment at a time when inflation is moving higher.

Consumers feeling less optimistic: The latest data from the Conference Board shows consumer confidence fell to 97 from the previous month’s final reading of 103.1. The latest decline marks the third consecutive month of falling optimism. The expectations index, which measures consumers’ short-term outlooks for income, the labor market and business conditions along with other categories, fell 7.6 points to 66.4, marking the lowest level since July 2022. Higher food and gas prices were the top concern among consumers. As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In April, those saying it’s hard to get a job rose to 14.9 percent, up from 12.2 percent the prior month. Meanwhile, those who viewed jobs as plentiful declined to 40.2 percent, compared to March's level of 41.7. The gap between those who find it hard or easy to get a job is the labor differential, something we track closely due to our belief that the current employment picture may make it difficult for the Fed to reach its target of 2 percent inflation. February’s labor differential came in at 25.5, down from March’s revised reading of 29.5.

While 12-month inflation expectations held steady at 5.3 percent, most respondents (53.8 percent) expect interest rates to rise in the year ahead.

Existing home prices rise: The most recent S&P CoreLogic Case-Shiller Index shows that home prices nationally rose 0.4 percent in February on a seasonally adjusted basis from the prior month. February’s reading shows home prices are up on a year-over-year basis, rising 6.4 percent since February 2023, marking eight consecutive year-over-year gains. The rise in prices comes despite interest rates on a 30-year fixed mortgage hovering above 7 percent. If home prices continue to rise faster than inflation, it would give landlords greater ability to raise rents in the future. A combination of higher home prices and rents would be a blow to the Federal Reserve’s efforts to bring inflation sustainably down to 2 percent.

Continuing jobless claims hold steady: Weekly initial jobless claims were 208,000, unchanged from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 210,000, down 3,500 from the previous week’s average. Continuing claims (those people remaining on unemployment benefits) stand at 1.774 million, unchanged from the previous week’s revised total. The four-week moving average for continuing claims rose to 1.788 million, down 3,750 from last week’s downwardly revised figure.

The week ahead

This week will be light on new economic data, but there will be plenty to follow as several Federal Reserve presidents will be making public statements throughout the week.

Monday: We’ll get the latest results from the Federal Reserve’s Senior Loan Officer Opinion Survey in the afternoon. The most recent survey showed lending standards at large and mid-sized banks continued to tighten. We will watch for signs of a change in lending criteria and the state of loan demand.

Tuesday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumer credit card debt has risen in recent months, but overall balance sheets have remained manageable.

Thursday: Initial and continuing jobless claims will be out before the market opens. Initial and continuing claims were down last week.  We’ll continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The University of Michigan will release its preliminary report on May consumer sentiment and inflation expectations. We will be watching to see if recent news of higher inflation has begun to weigh on consumers' expectations.