Inflation Data Bolsters Case for Fed’s Wait-and-See Approach

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

Equities rose over the past week as the Trump administration sketched out a plan that called for a targeted approach to tariffs instead of across-the-board levies on goods and services from trading partners. The proposal would also have the government study and eventually implement so-called reciprocal tariffs. These import duties would be set to match the tariffs trading partners charge on U.S. goods. While details have yet to be hashed out, investors saw the announcement as leading to a policy that could result in less potential for economic disruption than the steel and aluminum tariffs that were announced earlier in the week and are scheduled to take effect in mid-March. The President has already levied tariffs on goods from China and announced—and then paused–tariffs of 25 percent on trade with Canada and Mexico.

Relief on the trade front helped investors look past mixed inflation data and weaker than expected retail sales.

Last week’s Consumer Price Index (CPI) report from the Bureau of Labor Statistics (BLS) showed that inflation grew faster than expected in January, adding to a recent trend of steady or slowly rising price pressures. Investors’ initial concerns about the report eased somewhat following the release of the BLS’s Produce Price Index (PPI), which measures input costs for goods producers and service providers. Headline PPI came in above Wall Street estimates, while core PPI was in line with expectations. Importantly, details in the PPI release suggest that the Fed’s preferred measure of inflation, the Personal Consumption Expenditures index, could show continued progress in the disinflationary process when it is released at the end of this month.

It is unclear whether the jump in CPI was driven by annual price increases implemented in January that weren’t fully accounted for in seasonal adjustments to the data. Indeed, initial reaction to the hotter than expected data showed that investors didn’t view the rise as a long-term challenge. Shorter-term inflation breakevens (which show what the fixed income market expects the inflation rate to be in the future) have risen in reaction to the data, but longer-term breakevens remained relatively steady with the five-year, five-year forward breakeven (a measure of the average expected rate of inflation over the five-year period beginning in five years) remaining in a narrow range. This shows that so far the markets still believe inflation will be stable over the longer term.

Still, the size of uptick is likely to complicate the Fed’s decision-making process about cutting interest rates. Federal Reserve Chair Jerome Powell noted in testimony in Washington last week that the Fed can be patient in making future rate cuts. In comments in his appearance before lawmakers, Powell said, “We are close but not there on inflation. Today's inflation print ... says the same thing,” adding, “The economy is strong; the labor market is solid, and we have the luxury of being able to wait and let our restrictive policy work to get inflation coming down again. And that's what we’re doing."

While the economy as a whole remains solid, there have been signs of both broadening and a downshift in the pace of growth. Put simply, more parts of the economy are participating on the upside, but overall growth has slowed. Indeed, last week’s retail sales report highlighted that consumers’ appetites for spending may be cooling. Should this trend continue at a time when inflation remains stubborn, the Fed could find itself torn between the risk of cutting rates too quickly at the risk of reigniting inflationary pressures or cutting too late and risking a deterioration of the labor market, which could lead to further slowing of growth. Adding to the Fed’s challenge is the fact that we are in the late stages of an economic cycle, when even slight ripples in the costs of inputs, such as payrolls or raw materials, can lead to a rapid rise in the pace of inflation.

Fortunately, the economy has proven remarkably resilient despite persistent challenges in the aftermath of COVID. As such, the Fed may still be able to strike the right balance with rates that bring price pressures to heel while also easing rates by enough to keep the economy churning forward. However, we believe risks are still elevated and warrant your attention.

With that in mind, we continue to build broadly diversified portfolios that represent a balanced, long-term approach to investing. But we have tilted our portfolios toward cheaper asset classes that should benefit if economic participation broadens over the intermediate term. While this approach may mean the portfolios don’t fully participate when market distortions emerge, as they did last year, the benefit of diversification is that it is an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag, regardless of the economic backdrop. Indeed, we have already seen broadening in the market this year as previously overlooked asset classes, such as International Developed and Emerging Market equities along with commodities, are performing well on a relative basis.

Wall Street wrap

Inflation moves higher: The latest Consumer Price Index from the Bureau of Labor Statistics showed that prices rose 0.5 percent in January, up 0.1 percent from the prior reading and above Wall Street estimates. On a year-over-year basis, the headline figure was up 3 percent. Core inflation, which excludes volatile food and energy costs and is the measure that the Federal Reserve focuses on, rose 0.4 percent in January, double the 0.2 percent recorded in December. Over the past 12 months, core CPI is now up 3.3 percent; on a year-over-year basis, it has been stuck in a narrow range between 3.2 and 3.4 percent for the past nine months.

Goods prices rose 0.3 percent for the month, marking the fourth month of the past five that prices have increased. Those increases came after the measure fell during 13 of the prior 15 months. On a year-over-year basis, goods prices are still down 0.1 percent. The upward trend coincides with recent surveys that show an uptick in activity in the manufacturing side of the economy. We will continue to watch this trend to see if goods inflation is being reawakened by demand. As a reminder, easing goods prices have driven the disinflationary process over the past couple of years. Services prices rose 0.5 percent in January, up from 0.3 percent to close out 2024. They are now up 4.3 percent on a year-over-year basis compared to 4.4 percent year over year in December.

Because services readings include the lagging housing category, we typically look at so-called “super core” services—excluding shelter—to get a clearer picture of current measures of price pressures on the services side of the economy. Super core services prices were up 0.76 percent for the month and are up 4 percent year over year. On a three- and six-month annualized basis, super core services prices are up 5.37 and 4.81 percent, respectively. This shows that the trend is moving in the wrong direction.  

Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, also show a recent uptick in prices. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.32 percent in January, up from 0.27 in December. On a three-month annualized basis, the measure is up 3.46 percent, and the year-over-year reading comes in at 3.6 percent. Similarly, the Atlanta Fed’s Core Sticky measure was up 5.1 percent on a one-month annualized basis, with the year-over-year reading checking in at 3.6 percent. Like the other measures, this data shows that progress in bringing down inflation reversed in January. While it is possible that some of the uptick is a byproduct of annual price hikes in January that weren’t fully accounted for in seasonal adjustments, the size of the increase will likely give the Fed pause as it considers the timing of its next interest rate cut.

Retail sales slump: The latest retail sales numbers from the U.S. Census Bureau show that consumer spending shrank last month, with overall retail and food service sales declining 0.9 percent in January. The decline was greater than Wall Street expectations and a significant reversal from December’s growth of 0.7 percent.

Weakness was widespread with nine of 13 categories registering declines. Overall retail sales are up 4.2 percent year over year on a seasonally adjusted basis. Some of the decline could be the result of bad weather in January and consumers buying ahead in late 2024. Still, the Control Group (which is a proxy for the spending measure found in gross domestic product growth) was down 0.8 percent for the month, which could point to weaker economic growth to start the year.

Small business owner optimism slips: The latest data from the National Federation of Independent Businesses shows that optimism among small businesses eased 2.3 points in January, with a reading of 102.8. While down, the latest reading marks the third consecutive month of readings above the 51-year average of 98. The step back in optimism was widespread, with seven of the 10 components measured showing decreases, one showing an increase and two unchanged. Meanwhile, the Uncertainty Index jumped to 100, rising 14 points and notching the third highest reading in the survey’s history.

A closer look at the report shows that expectations continue to support optimism but that views have eased from the end of 2024. The net percentage of respondents who expect the economy to improve fell five points in January to 47 but is still at the second highest level in the past five years. Perhaps most striking about the report is that despite the generally positive outlook, business owners are still concerned about inflation, with 18 percent listing it as their top challenge, tied with quality of available labor as the top concern they are facing.

A generally upbeat view of the future was evident in still positive sales expectations. Sales for small businesses have been in decline since June 2022, including the latest reading showing a still historically depressed 14 percent more businesses (one point worse than in January) reporting declining sales than reporting flat or rising purchases. Despite the prolonged weakness, the latest survey shows that business owners are confident about a reversal of fortune, with a net 20 percent of those surveyed expecting sales to grow in the next three months. This marks a modest two-point decline from the previous month, marking the second highest reading since February 2020. For further context, the measure hit a recent low in August 2024, when a net 18 percent of businesses expected falling or flat sales in the next three months.

Should sales improve, it would be a welcome relief for businesses that have grappled with weak sales since COVID. The latest reading shows a net 25 percent of business owners have seen their earnings shrink over the past three months, a one-point improvement from December’s reading. Although the latest reading is still weak, the trend has shown some improvement since August 2024, when a net 37 percent of businesses reported shrinking earnings.

The portion of businesses expecting to hire in the next three months eased slightly in January. The latest results show 18 percent of companies expect to add to payrolls, a decrease of one point from December. Those who are hiring continue to struggle finding qualified help, with nearly half (47 percent) of those hiring reporting a lack of qualified candidates. As we’ve noted in the past, a scarcity of qualified workers can lead to a rise in wages. To that end, 33 percent of businesses reported raising compensation in the past three months, up four points from January. However, the latest survey results show the portion of businesses expecting to raise wages in the next three months declined to 20 percent, down four points from December and the lowest reading since August 2024. For further context, the measure hit a recent low of 18 percent in July 2024.

The latest results show pricing power was little changed, with 22 percent of small companies raising prices over the past three months, down two points from December. For context, this is well off the post-COVID peak of 65 percent in May of 2022 but still elevated by historic standards.

The week ahead

Tuesday: The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders rose modestly last month thanks to expectations of economic growth. At the same time, builders also expressed concerns about the impact potential tariffs and elevated mortgage rates may cause. We’ll be watching to see if builders’ optimism has wavered in response to signs of continued inflation pressures and rhetoric out of Washington about the implementation of tariffs.

Wednesday: The day offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for board members’ thoughts on the employment picture and wages as well as discussions about pockets of sticky inflation.

We’ll get January housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Tuesday, will provide insight into the home construction market.

Thursday: The Conference Board’s latest Leading Economic Index Survey for January will be out mid-morning. Last month’s report showed some weakening after a string of reports have shown modest improvement but still point to weak economic growth ahead for the U.S. economy. We will be scrutinizing the data to see if last month’s decline was a temporary setback.

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 February. Activity eased last month in services, while manufacturing showed signs of expansion. We will be watching to see if the improved balance between the two sides of the economy is showing signs of taking hold. 

We’ll get additional insights into the housing market when the National Association of Realtors releases existing home sales for January. This report, along with the new homes data released earlier in the week, should give a clearer picture of whether the housing market remains stalled due to high interest rates. 

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