Inflation Continues to Fall Against the Backdrop of a Resilient Economy

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

Over the past 18 months or more, we have been talking a lot about inflation. Simply put, we believed there was room for the market to move higher as inflationary fears receded. Last week, faltering inflation was on display again in the data as the Personal Consumption Expenditures (PCE) index (the Fed’s preferred measure of inflation) fell to the lowest level in nearly two years. Headline prices were up 3 percent from June 2022 and a mere 0.2 percent on a month-over-month basis. Core PCE, which eliminates volatile food and energy prices, was up 4.1 percent year over year.  

What’s more, this pullback in inflation comes against the backdrop of a resilient American economy. Advance estimates from the Bureau of Economic Analysis show the U.S. economy grew faster than expected in the second quarter, with real gross domestic product coming in at a seasonally adjusted annual rate of 2.4 percent. Consumption came in at a moderate 1.6 percent, with goods spending up 0.7 percent and services up 2.1 percent, while fixed investment was up 5.7 percent.  

Markets moved higher last week amid this backdrop and the Federal Reserve’s decision to hike rates by 0.25 percent. Still, we believe a recession is still likely over the coming quarters, as the Fed remains committed to keeping interest rates elevated and liquidity constrained to slow down a still hot labor market that has led to strong wage gains. Put differently, the Fed fears that rising wages could reignite inflationary pressures. While hopes of a soft landing have risen, we note that over the past 60-plus years the only way the Fed has pushed wages significantly lower is through rising unemployment and recessions. 

Wall Street wrap 

Consumer confidence jumps amid falling inflation: Consumer confidence hit a two-year high in July amid easing inflationary pressures and signs of economic resilience despite the higher interest rate environment. The Conference Board’s consumer confidence index rose to 117, well up from 95 last July and the highest level since July 2021. 

As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In July, those saying it’s hard to get a job fell to the second lowest reading on record, 9.7 percent. The gap between those who find it hard or easy to get a job is the labor differential, something we’ve been tracking closely due to the Fed’s keen interest in the employment picture. July’s labor differential widened to 37.2, up from 32.8 in June. This is a sign that the labor market remains tight and foreshadows a potentially strong jobs report this week. 

Jobless claims continue to fall, while wages remain elevated: Fewer people filed jobless claims last week than in the week prior, with new claims dropping to 221,000 from last week’s 228,000. The four-week rolling average of new jobless came in at 233,750, from 237,500 the previous week. Continuing claims (those people remaining on unemployment benefits) dropped to 1.690 million, down 59,000 from the prior reading. 

Better than expected wage data from Friday’s Bureau of Labor Statistics (BLS) Employment Cost Index showed that compensation costs for civilian workers increased 4.5 percent for the 12-month period ending in June 2023, with wages and salaries up 4.6 percent. While wages pressures have eased in 2023, they likely remain too high for the Fed’s comfort.  

Housing market shows signs of stabilizing: Home prices rose in May for the fourth consecutive month after seven months of decline on the S&P Corelogic Case-Schiller home price index. Seasonally adjusted, the 20-city index rose 0.99 percent month over month. While home prices on this measure have recently risen, they remain 1.70 percent lower year over year. 

While existing home sales remain near post-COVID lows, new home sales have stabilized. The U.S. Census Bureau reported that new home sales in June were at 697,000 on a seasonally adjusted annualized rate, down from last month’s 715,000 but well above last June’s 563,000 pace.   

Services continue to bolster economy, but sector growth is slowing: The latest preliminary data from the S&P Global Composite Purchasing Manager’s Index, which tracks both the manufacturing and service sectors, indicated that the economy grew at the slowest pace in five months. The Composite Output Index reading came in at 52, down from June’s reading of 53.2. While readings above 50 are an indicator of growth, these numbers reflect a slowdown in service-sector growth to a five-month low. 

While manufacturing continues to be stuck in contractionary territory, the headline reading for manufacturing rose to 49 in July, up from the prior month’s reading of 46.3. By and large, manufacturing firms saw production unchanged thanks to backlogs of work and a smaller drop in new orders. Where companies did register a rise in output, it was generally linked to sustained demand and new customer acquisition. That said, demand was dampened overall by customer spending constraints, including high interest rates. 

While the services sector remains in growth mode, with a headline reading of 52.4 (down from 54.4 the prior month), we’re starting to see a slowdown in the pace of that expansion despite a rise in new orders. 

Both sides of the economy expanded their workforce numbers at the start of the third quarter. While the rate of job creation was marginal overall (the weakest since January), manufacturers experienced a stronger uptick, and the services side is starting to even out. The rise in manufacturing headcount was largely attributed to ease of hiring, improved employee retention and a confident economic outlook. 

Fed rate hike raises borrowing costs to highest level in 22 years: Last Wednesday, the Fed approved a highly anticipated rate hike that elevated benchmark borrowing costs to the highest level in more than 22 years. The 0.25 percent hike brings the fed funds rate to a target range of 5.25–5.5 percent, levels not seen since 2001. In June, policymakers indicated that two additional rate hikes would likely be forthcoming in the second half of 2023, but last week Fed Chair Jerome Powell indicated the central bank will continue to make data-based decisions on a “meeting-by-meeting” basis. During his press conference the chair stated, “Given how far we have come, we can afford to become a little patient.”  

While this comment was taken as a positive by the market, we believe a more telling statement occurred later in the press conference. During a question on wages, the chair commented that current levels of wage growth are not consistent with 2 percent inflation. We believe this will be the most important variable pushing forward, as the Fed will want to see some softening in the labor market. We believe this will be the final frontier in the inflation fight as the Fed worries about a wage–price spiral just like what happened in 1966–1982. The concern is that if wages stay elevated, they will pull current PCE and the Consumer Price Index back higher. A review of the past three economic cycles reveals a Fed that has aggressively tightened monetary policy as wage growth approached 4 percent year over year, which has capped wages in the low 4 percent and led to a recession in each and every instance. With current wage growth in the mid-4 percent range on various measures, we believe the Fed will continue to keep rates elevated until it sees the labor market softening, which we believe will cause a recession.   

The week ahead  

Tuesday: The BLS will release its Job Openings and Labor Turnover Survey report. We’ll watch for indications that the gap between job openings and job seekers is narrowing, which would help ease wage pressure for businesses. 
 
The manufacturing sector will again be in the spotlight as the Institute of Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index. Recent readings have shown the sector in contraction territory, and we will monitor for any signs of change in direction. 

Thursday: Before the opening bell, initial and continuing jobless claims will be announced. Initial filings were down last week, and we will keep our eyes open for signs of softening in the job market. 

The ISM will also release its latest services industry report Thursday. Recent readings have shown slowing growth in the sector, and we will keep our eyes open for indications that this trend continues.  

Friday: The BLS will release the Jobs report. Recently, we noted the difference that has grown between the Nonfarm Payrolls report and the Household report. We’ll continue to watch for signs of narrowing in that gap as well as any changes in hourly earnings for workers. 

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