Hot Inflation Readings Dash Hopes for Near-Term Rate Cuts

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

Expectations that the Federal Reserve would begin cutting during the first half of this year were dealt a blow last week as inflation readings came in higher than expected, suggesting that the much-heralded progress on reducing the pace of rising prices may be running out of steam. The latest Consumer Price Index from the Bureau of Labor Statistics showed that headline inflation increased in January and came in higher than Wall Street expectations. Headline inflation rose 0.3 percent for the month and was up 3.1 percent on a year-over-year basis. The monthly increase was up from December’s 0.2 percent gain. Core inflation, which excludes volatile food and energy costs, rose 0.4 percent in January, up from November’s pace of 0.3 percent, and is up 3.9 percent on a year-over-year basis.

Several members of the Federal Reserve used the latest data to bolster the argument made by Fed officials during the past few weeks that there is room to be patient and that the data doesn’t support aggressive cutting. While the comments were often couched with reassurances that the latest figures may end up being simply a bump in the ongoing disinflationary process, most of the members who spoke out struck a tone similar to that of San Francisco Federal Reserve president Mary Daly, who noted “progress is not victory” as she advocated for a gradual approach based on economic data. One seeming outlier among the Fed presidents to comment on the recent data was Chicago Fed president Austan Goolsbee, a non-voting member of the Fed who said during a question and answer period following a public speech: “Let’s not get amped up when you get one month of CPI that was higher than what you expected it would be. It is totally clear that inflation is coming down.”

Although we acknowledge that considerable progress has been made in reining in prices, we view that the latest Consumer Price Index (CPI) data isn’t so much an outlier as it is consistent with other measures we follow that show the disinflationary process appears to be hitting a wall. Indeed, the latest monthly reading of one of the Cleveland Federal Reserve’s inflation measures, called Median CPI, came in at 6.5 percent annualized, up from December’s reading of 4.2 percent and at the highest level since February 2023. The measure had been falling from post-COVID highs through July 2023 but has since been trending upward.  According to research from the Cleveland Fed, the median CPI provides a better signal of the underlying inflation trend than either the all-items CPI or the CPI excluding food and energy. The median CPI is even better than the core Personal Consumption Expenditures (PCE) price index at forecasting PCE inflation in the near and longer terms. Another measure of inflation, the Atlanta Federal Reserve’s Sticky Consumer Price Index, rose at an annualized pace of 6.7 percent in February. Over the past three months, this measure shows inflation rising at an annualized rate of 4.8 percent after bottoming in July 2023. Simply put, the trend suggests inflation readings are going the wrong way. Both measures support our view that the underlying cause of inflation has shifted to being driven by factors typically seen late in a business cycle, when inflation becomes “stickier” and is harder to extinguish.

We highlight this trend not to suggest that we are heading back to the inflation readings seen in the summer of 2022 but instead to explain our view that given the strength of the labor market and seeming resilience of the economy, the Fed likely believes the risks from cutting rates too soon outweigh those of waiting too long.

Unfortunately, given that labor is typically a lagging indicator of the economy, by the time the Fed sees the evidence it needs that wages are no longer a threat to create a wage–price spiral like that seen in 1966–1982, a slowdown may have already taken root. As we’ve highlighted in recent commentaries, economic data has shown some underlying softening. If the labor market remains tight even as the economy downshifts, we could see an environment where slowing growth leads to eventual layoffs, which puts additional strain on the economy and eventually leads to recession. Fortunately, if a contraction arrives, the Fed should be able to quickly pivot to cutting rates to prevent a shallow recession from gaining momentum.

Wall Street wrap

Headline CPI readings grabbed the headlines, but other data out last week reinforced the lingering challenges in bringing inflation back down to the Fed’s target of 2 percent.

More on inflation: The latest CPI report did include some positive news: prices for goods declined by 0.3 percent, marking the seventh time in the past eight months that goods prices fell—and the one month they did not fall, goods prices were unchanged. As a result, goods inflation is now down 0.3 percent year over year. Services inflation, however, remains stubbornly “sticky” and rose 0.7 percent for the month and is up 5.4 percent year over year. Shelter costs, which had been slowing until recently, are once again boosting the overall services reading. However, when these costs are stripped out, services (excluding rent of shelter) prices were still up 0.6 percent on a seasonally adjusted basis in January, on the heels of a 0.4 percent increase in December. This puts the year-over-year pace of services prices excluding shelter at 3.6 percent, which is up from the prior month’s 3.4 percent. This measure hit a low of 2.8 percent year over year in September 2023 and has accelerated since then, with the last three months running at a 6.5 percent pace annualized and a six-month annualized rate of 5.6 percent. The Fed would like to see further progress in bringing services inflation under control, and the recent upward trend may be a cause for concern to members of the Fed.  

Input costs rise: Producer input final demand prices came in above Wall Street expectations, rising 0.3 percent in January, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The latest monthly reading is up from December’s 0.1 percent decrease and marks the highest reading since August 2023. On a year-over-year basis, headline PPI is up 0.9 percent. Core PPI, which strips out volatile food and energy, was up 0.5 percent for the month, up from December’s 0.1 percent decrease. Core PPI was up 2 percent on a year-over-year basis, up from 1.7 percent in the prior month. 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. 

Small business owners’ pessimism increases: The latest data from the National Federation of Independent Business shows optimism among small businesses extended its streak of below-average readings to 25 consecutive months. Optimism declined in December to 89.9, down 2 points from December’s reading and well below the 50-year average of 98. Similarly, optimism over business conditions in the coming six months drifted lower to a reading of a net negative 38 percent, a decline of 2 points from December. The latest economic outlook reading continues a streak of results at levels usually seen during or leading up to recessions.

The overall decline in outlook coincides with a significant drop in the number of respondents who expect higher sales in the coming months. The latest reading on this question shows a net negative 16 precent of small business owners expect an increase in retail sales, marking a 12-point decline from December and the lowest reading since last May.

As has been the case for several months, labor quality and inflation continue to be top concerns among respondents. A total of 39 percent of business owners reported job openings they could not fill, and 21 percent listed finding qualified candidates as a top concern. To compete for limited available workers, a net 39 percent of small businesses reported raising wages during the past month (up three percentage points from December), and an additional 26 percent plan to raise compensation in the coming three months. While the number planning to raise pay is down 3 points from December’s reading, it remains at historically high levels. Immediately after COVID it briefly peaked at 50 percent in January 2022 but otherwise has never risen above 34 percent going back to 1985. The current elevated level suggests that wage growth is unlikely to see a meaningful slowdown in the near term.

Inflation was listed as the top concern by 20 percent of those surveyed, down 2 points from December. As business owners continue to worry about inflation, 33 percent of those surveyed plan to raise prices in the next three months, up one point from December. For context, the portion of small businesses planning to raise prices hit a post-COVID low of 21 percent in April 2023 but has since been trending higher. Companies planning to raise prices at a time when compensation plans suggest labor costs are also moving higher could set the stage for a wage–price spiral should these trends persist.

Consumer optimism inches higher: Consumer sentiment continued its recent climb, moving to 79.6 in February, up 0.6 points from January’s final reading of 79, according to the latest consumer sentiment survey released by the University of Michigan. The preliminary readings come on the heels of a surge in expectations in December and January. Respondents remain confident that inflation will continue to fall and the labor market will remain strong, according to the latest data. As a result, five-year expectations for business conditions climbed 5 percent in February and are now at the highest level since December 2020.  

Results from the survey show that inflation expectations remain well anchored, with respondents anticipating prices rising 3 percent in the coming year, up slightly from January’s reading of 2.9 percent. Long-term inflation expectations held steady at 2.9 percent for the third straight month. For context, long-term inflation expectations have fallen in a range of 2.9 percent to 3.1 percent in 28 of the past 31 months. It’s worth noting that sentiment started to move sharply higher beginning in December as the Federal Reserve began to signal that the rate tightening cycle had likely concluded and it expected inflation pressures to continue to ease. Similarly, 38 percent of respondents still expect interest rates to decline in the year ahead. The latest reading is at a historically high level. By comparison, just 12 percent of respondents last November anticipated rates to decline. Given recent data that suggests that the disinflationary process may have stalled, along with comments from members of the Federal Reserve that rates may need to stay at current levels for longer, we will be watching this measure to see if the improvement in the outlook of consumers persists.

Consumer spending falters: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in January declined by 0.8 percent, significantly lower than December’s gain of 0.4 percent and well below Wall Street estimates. The January figure marked the largest decline since March 2023. The latest report shows retail sales are up 0.6 percent on a year-over-year basis. Weakness was widespread, with nine of the 13 categories seeing decreases. Strong consumer spending has been a driving force in economic growth following the onset of COVID, and we will be watching future releases to see if consumers are beginning to pull back on their spending habits now that excess savings accumulated during COVID has largely evaporated.

Jobless claims remain low: Weekly initial jobless claims numbered 212,000, a decrease of 8,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 218,250, up 5,750 from the prior week. Continuing claims (those people remaining on unemployment benefits) were at 1.895 million, an increase of 30,000 from the previous week. The four-week moving average for continuing claims rose to 1.87 million, up 22,500 from last week’s revised figure.

The week ahead

Tuesday: The Conference Board’s latest Leading Economic Index survey for January will be out mid-morning. For months, these reports have suggested the U.S. economy may be on the cusp of or is in a recession. The data improved modestly last month, and we will be watching to see if the uptick has become a trend.

Wednesday: Wednesday offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for comments related to the potential timing of rate cuts as well as board members’ thoughts on the employment picture and wages.

Thursday: 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 February. Activity in manufacturing strengthened last month but remains near neutral, while the services side has shown continued resilience. We will be watching for signs to determine whether both sides of the economy have seen an uptick in price pressures. We’ll also be paying close attention to demand for employment in both industries.

The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures, and we will be watching for signs of slowing economic growth.

Initial and continuing jobless claims will be announced before the market opens. Initial filings fell last week, while the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

We’ll get a look at existing home sales mid-morning from the National Association of Realtors. This report, along with the new homes data released earlier in the week, should give a clearer picture of whether recent signs of stabilization continue in the face of an uptick in mortgage rates.

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