Declining Inflation and a Pause by the Fed Sends Markets Higher

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

Equities continued their recent march higher last week with the S&P 500 notching a fifth consecutive week of gains and hitting highs last seen in April 2022. The Federal Reserve’s decision to hold rates steady, along with inflation data that showed prices rising at the slowest pace in more than two years, sparked a wave of buying even as the Fed indicated it may raise rates two more times by year end.

Progress in the deflationary process was evident in the latest Consumer Price Index (CPI) release, which shows that headline inflation grew at a scant 0.1 percent in May, down from April’s rate of 0.4 percent. On a year-over-year basis, prices rose 4 percent, marking the slowest 12-month increase since March 2021. Both the monthly and year-over-year increases were lower than Wall Street expectations. Shelter was once again a driving force of the increase in headline readings, with an increase of 0.6 percent for the month. On a year-over-year basis that category was up 8 percent in May, a decrease of 0.1 percent from the prior reading. As a reminder, shelter has a large and lagging effect on inflation readings in services (it accounts for 34 percent of the total CPI measure and has around a 12-month lag).

As we’ve noted in previous commentaries, given the lagging nature of the shelter reading, we believe it is useful to evaluate price pressures after stripping out this backward-looking measure. Doing so highlights the significant progress made in bringing inflationary pressures down. Since the surge in CPI readings that took place in May and June of 2022, prices excluding the shelter number are up just 2.1 percent annualized on a non-seasonally adjusted basis and up 0.4 percent when adjusting for seasonality. Put simply, when excluding the lagging shelter reading, all-in inflation is running at a level consistent with the Fed’s stated target. We highlight the rate following the June peak to show why we believe year-over-year CPI readings are set to tumble in the coming months as the extreme increases from May and June roll off the twelve-month total.

Core CPI, which excludes volatile food and gas prices, rose 0.4 percent in May, unchanged from April’s reading. On a year-over-year basis, the core reading came in at 5.3 percent, down from April’s rate of 5.5 percent. Although still elevated, it’s important to note that the latest year-over-year reading is the slowest 12-month increase since November 2021. Once again, if shelter is taken out of the equation, core CPI drops to 3.4 percent year over year and stands at just 2.8 percent annualized during the past nine months.

Dissecting the data further reveals that food and shelter combined have been significant drivers of high year-over-year readings. When those two categories are removed, all-in inflation is up a meager 1.1 percent, below the Fed’s long-term target of 2 percent. It’s worth noting that the latest report showed food prices have moderated and were up just 0.2 percent month over month.

Further evidence that inflation pressures have largely retreated save for a few pockets can be found in the latest data from the Atlanta Federal Reserve Bank’s so-called Sticky CPI-Ex Shelter measure, which shows that core “sticky” inflation, excluding lagging shelter, is running at an annualized pace of 1.59 percent in June, down from a three-month annualized rate of 2.5 percent. On a year-over-year basis, the measure is up 3.9 percent.

Similarly, the Cleveland Federal Reserve calculates an inflation reading called the 16 Percent Trimmed Mean CPI that excludes abnormally high and low categories. The last three monthly readings of this indicator show price increase percentages of 0.22, 0.33 and 0.22, respectively. This highlights that inflation pressures in most categories are at or approaching the Fed’s stated target.

The purpose of this deep dive into various inflation measures is to underscore why we believe the battle against rising prices is well on its way to being won. However, given the fact that the Fed’s forecasts for the remainder of the year call for two additional 25-basis-point hikes, we believe some members of the Fed may not be willing to rest until the seemingly resilient job market weakens and results in a recession. While wage pressures have retreated in recent months and wage expectations remain muted, the threat of a resurgence in wages that could be used to pay ever-higher prices appears to continue to haunt some members of the Fed. As such, we continue to believe there is risk the Fed will overshoot to the upside on rates, and the economy will slip into a shallow, mild recession.

Wall Street Wrap

Here are some of the other items that caught our attention in a week of light data.

Input costs recede further: Producer input final demand dropped in May, coming in at -0.3 percent, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The latest reading marks the second in the past three monthly reports in which prices fell. On a year-over-year basis, headline PPI is up 1.1 percent, down from May’s reading of 2.3 percent, which was below market expectations and at the lowest level since December 2020. Core PPI, which strips out volatile food and energy, was unchanged in May and was up 2.8 percent on a year-over-year basis, which was the lowest 12-month reading since January 2021. The PPI measures price increases for finished goods leaving the factory; it is generally a forward-looking measure of where prices for consumers are headed. As the costs producers face for finished goods continue to ease, we expect to see further price relief for consumers at the retail level.

Jobless claims jump: Weekly jobless claims were unchanged from last week’s upwardly revised 262,000 new claims, the highest level since October 2021. While weekly filings can be volatile, the four-week rolling average of new jobless claims rose to 246,750, an increase of 9,250 from the previous week and the highest reading since November 2021. We pay particular attention to the four-week rolling average because it smooths out some of the volatility seen in the weekly claims. Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.775 million.

Wage expectations muted: The latest consumer sentiment survey released by the University of Michigan shows consumers on average expect their wages to grow just 1.7 percent in the coming year. For context, the reading reached 6.5 percent in 1980, when inflation was embedded in the economy.

Inflation expectations also remained anchored, with respondents expecting prices to rise 3.3 percent in the coming year. That figure is down from 4.2 percent in May and the lowest level since April 2021. Long-term inflation expectations remained stable at 3 percent, inside the range of 2.9 to 3.1 percent recorded during the past 23 months.

Overall, the consumer sentiment index improved to 63.9, up from last month’s reading of 59.2. While the jump is encouraging, the level is still consistent with levels registered during previous recessions.

Small businesses remain relatively cautious: The latest data from the National Federation of Independent Business shows optimism among small business owners inched higher to 89.4, up 0.4 points from April. However, the reading remains well off from its 49-year average of 98. According to commentary detailing results of the survey, “Overall, small business owners are clearly in a recession mood, expressing great concern for future business conditions. But until customers stop coming in, owners (especially in services) will continue to try to hire workers, increasing compensation to attract applicants and retain their current workforce.”

Retail sales tread water: The latest retail sales numbers out from the U.S. Census Bureau came in above Wall Street expectations. The report shows overall retail sales in May were up 0.3 percent month over month, compared to Wall Street expectations of a decline of 0.2 percent. It is important to note that the retail numbers are not adjusted for inflation. When accounting for price increases during the month, sales were essentially flat. Sales were up 1.6 percent on a year-over-year basis, modestly above the 1.2 percent year-over-year increase recorded in April, which marked the smallest 12-month rise since May 2020. Motor vehicle and auto parts sales were a driving force for both the monthly and year-over-year increases.

The week ahead

Monday: A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders.

Tuesday:  We will get May housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Monday, will provide insights on whether consumers can expect greater housing inventory in the months ahead.  

Wednesday: Fed Chair Jerome Powell heads to Capitol Hill to present his semi-annual monetary policy report. We will be listening to his comments for indications of how he views the balance of risks between controlling inflation and economic damage and a rise in unemployment that may result from additional rate hikes.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings were up last week, and we will be watching to see if recent signs of some softening in the job market have taken root.

 We’ll get a look at existing home sales mid-morning by the National Association of Realtors. This report, along with the new homes data released earlier in the week, should provide a clearer picture of whether the real estate market continues to stabilize.

The Conference Board’s latest Leading Economic Index survey for May will be released shortly after the market opens. For the past several months, the report has suggested the economy is on the cusp of or in a recession. We will be scrutinizing the data for any indications of a change in the pace of softening.

Friday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for June. Activity for manufacturing continues to show weakness, and growth on the services side has shown some signs of slowing. We will be watching for signs that growth on the services side continues to cool.

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