Inflation Reading Marks a Step in the Right Direction, but the Fed Likely Needs More

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

Economic data out last week offered some positive news on the inflation front, as the latest Personal Consumption Expenditures (PCE) Index from the Bureau of Economic Analysis showed inflation eased in May. The latest PCE reading along with the most recent Consumer Price Index report released earlier in June suggest that the uptick in prices seen earlier in the year has stalled, and the disinflationary process may have restarted. While that is good news, it will be important to assess what’s behind the easing prices. Is inflation easing because wage growth is cooling, or is it because demand is slowing? Typically, declining inflation is tied to easing demand, which can lead to economic weakness and an eventual recession. And while we believe one month’s worth of encouraging data will not be enough to convince the Federal Reserve that it is well on the path to bringing inflation sustainably down to 2 percent, we also think it is unlikely that the Fed will be able to cut rates yet even if the economy is slowing. That’s because, late in the business cycle, when the economy is producing above its long-term growth capacity and resources are stretched thin, even mild inflationary pressures quickly translate into rising prices. 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.

We frequently note the period of 1966–1982 as the defining period Federal Reserve Chairman Jerome Powell is most concerned about not repeating. That’s because the Federal Reserve at that time failed to finish the job in bringing inflation to heel, which led to the wage–price spiral that lasted for more than a decade. The Fed’s fear of repeating the mistakes of that period has made it hesitant to cut rates until it is convinced that the risks of inflation reigniting are essentially snuffed out. However, we believe a more recent period has also chastened the Fed. Recall that in December 2023, the Fed updated its projections for rates, inflation and economic growth and took a much softer tone. The projections, along with encouraging comments by Chairman Powell at the time, resulted in widespread anticipation of multiple rate cuts in 2024, a surge in the equity markets and looser financial conditions.

The euphoria was short-lived, however, as inflation inched higher during the first quarter of the year and expectations of rate hikes in the first half of the year dimmed. We believe the loosening of financial conditions in late 2023 may have contributed to the temporary resurgence in price pressures. The Fed is likely looking to avoid a repeat of the recent uptick in inflation and will be more conservative in its estimates and public statements going forward. Given that additional pauses in the disinflationary process could lead to elevated inflation becoming embedded in the economy, we believe the Fed will hold off on cutting rates until there have been several months of easing inflation readings, and the economy is showing clear signs of cooling in the form of net job losses and a slowdown in wage growth.

Unfortunately, given that the labor market and wage growth are lagging indicators of the economy, by the time the Fed sees evidence that inflation is sustainably headed to its target of 2 percent, it may be too late to avoid a recession. Indeed, we have been highlighting signs of weakness in the economy for the past several months, yet wage growth is still elevated, and inflation has only recently started to decline again. Even when the Fed concludes it is safe to cut rates without reigniting inflation, it may be too late. Recall that the Fed cut rates prior to the beginning of the last four recessions, yet the momentum of softening growth still progressed to a recession.

As we have noted in the past, the path forward boils down to which will break first—inflation or the economy. When viewed from that perspective, we believe momentum still suggests the economy is headed for a recession. Fortunately, with inflation showing some signs of easing again after an uptick earlier in the year, the Fed may eventually have more room to cut rates, which would increase the likelihood that the recession is mild.

Wall Street wrap

Signs of easing inflation: The latest reading from the PCE index from the Bureau of Economic Analysis showed that core inflation, which strips out volatile food and energy prices, rose 0.1 percent in May—in line with Wall Street estimates. However, the prior month’s reading was revised up to 0.3 percent from the original estimate of 0.2 percent. On a year-over-year basis, core inflation was up 2.6 percent, also consistent with consensus estimates.

The cost of goods fell 0.4 percent in May, down from April’s 0.2 percent increase. Services prices rose by 0.2 percent, down from April’s 0.3 percent pace. On a year-over-year basis, inflation for services came in at 3.9 percent, down from April’s reading of 4 percent. Since the beginning of the year, services inflation has been hovering in a year-over-year range of 3.9 to 4 percent. The consistent elevated readings are an example of why we believe the Fed’s work is not finished. Digging deeper, so-called “super core” services inflation, which strips out housing, rose 0.1 percent in May. However, the three-month annualized pace remains elevated at 3.3 percent, and the six-month annualized pace comes in at 4.1 percent, which serves as another reminder of the stickiness remaining in price pressures. Goods prices are down 0.1 percent year over year, compared to a 0.1 percent year-over-year increase in April.

The progress against inflation was also captured in one of the secondary inflation reports we follow. The Dallas Federal Reserve’s Trimmed Mean PCE, which removes outliers that can distort traditional PCE readings, shows that the one-month annualized inflation rate is at 1.4 percent. However, the six-month annualized rate remains elevated at 3 percent, as is the 12-month rate at 2.8 percent. As members of the Fed noted after last week’s data, this is good news, but more progress is needed to bring inflation sustainably back to 2 percent.

Consumers wary about the future: The latest data from the Conference Board shows consumer confidence declined to 100.4 in June from the previous month’s final reading of 101.3. The expectations index, which measures consumers’ short-term outlook for income, the labor market, business conditions and other categories, fell 1.9 points to 73. Consumers’ views of current business conditions fell; however, a strong labor market once again boosted the overall reading. As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In June, those saying it’s hard to get a job declined to 14.1 percent, down from 14.3 percent the prior month. Those who viewed jobs as plentiful rose, coming in at 38.1 percent, modestly higher than May’s reading of 37 but well below the 47.1 reading recorded in March 2022. The three-month moving average for this question is now at the lowest level since the end of COVID. The gap between those who find it hard or easy to get a job is the labor differential. Typically, the greater the differential, the stronger the job market. We track the differential closely because of our belief that the current employment picture may make it difficult for the Fed to reach its target of 2 percent inflation. June’s labor differential came in at 24, up from May’s revised reading of 22.7.

Inflation expectations for the next 12 months eased slightly to 5.3 percent (down 0.1 percent from the prior month). Purchasing plans for homes were largely unchanged in June despite a drop in the portion of respondents who think interest rates will rise in the coming year. The latest survey shows 52.6 percent expecting higher rates, the lowest reading since February, when rate cut expectations were still widespread. While expectations of higher rates eased, the outlook for business conditions in the next six months fell to 12.5, which marks the lowest reading since 2011.

Capital spending falters: Preliminary readings show business fixed investment declined in May, with nondefense capital goods orders, excluding aircraft, declining 0.6 percent after a 0.3 percent rise the prior month. Shipments declined by 0.5 percent compared to a 0.4 percent increase in April. On a year-over-year basis, goods orders are down 0.2 percent, and shipments are down 0.1 percent. This measure can serve as a proxy for business investment for future growth or increased productivity. As such, the latest figure may point to weaker growth in the future.

Continuing jobless claims move higher: Weekly initial jobless claims were 233,000, down 6,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 236,000, up 3,000 from the previous week’s average. For additional context, the four-week rolling average was just 200,750 in January.

Continuing claims (those people remaining on unemployment benefits) stand at 1.839 million, up 18,000 from the previous week’s revised total and just off the highest level since November 2021. The four-week moving average for continuing claims came in at 1.816 million, up 12,250 from the previous week. Both of these are on an uptrend, and we are watching this measure closely.

More states trigger the Sahm rule: The latest data from the Bureau of Labor Statistics (BLS) shows that 22 states are now triggering the so-called Sahm rule (regular readers of our commentaries may recall this rule, developed by former Federal Reserve Economist Claudia Sahm). According to the rule, since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous low, a recession followed. Additionally, going back to 1976, whenever this large a portion of the states have met the conditions of the Sahm rule, a recession has followed. Claudia Sahm has noted that it was meant to be applied to national employment data, not individual states. While the national unemployment rate is not yet at the threshold identified by the Sahm rule, it’s noteworthy that 44 percent of the states representing 48 percent of the nation’s population have seen unemployment rise by at least 0.5 percent of the previous three-month rolling average low. Included in the states in accord with the Sahm rule are California, Illinois and Florida, which represent three of the six largest states in the country by population. In recent media appearances, Sahm has noted that while the national unemployment numbers haven’t yet risen to the threshold in the rule, state-level readings are a concern and are pointing in the wrong direction.

Existing home prices rise: The most recent S&P CoreLogic Case-Shiller Index shows that home prices nationally hit another all-time high, rising 0.3 percent on a seasonally adjusted basis from the prior month. April’s reading shows home prices are up on a year-over-year basis, rising 6.3 percent since April 2023, marking 11 consecutive year-over-year gains. The rise in prices comes despite interest rates on 30-year fixed mortgages 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.

New home sales and pending home sales decline: New home sales declined to 619,000 units in May, according to the latest data from the U.S. Census Bureau. The latest figure is down 11.3 percent from April’s revised total of 698,000. On a year-over-year basis, new home sales are down 16.5 percent. Sales prices also declined. The median price of a new home was essentially flat, coming in at $417,400, down from $417,900 in April. On a year-over-year basis, prices were also essentially flat (albeit at elevated levels) down 0.9 percent. 

Pending home sales also decreased in May, with the Pending Home Sales Index dropping 2.1 percent and reaching the lowest level in the 23-year history of the index, according to the latest report from the National Association of Realtors. On a year-over-year basis, the index is down 6.6 percent to a reading of 70.8. For context, the index was as high as 125.1 in October 2021. Pending sales measure transactions for which a purchase contract has been signed but the deal has not yet closed. They are a leading indicator of existing home sales because contracts are often signed one to two months before the deal is closed. Typically, about 80 percent of pending sales become existing home sales within two months.

The week ahead

Monday: The manufacturing sector will be in focus as the Institute for Supply Management (ISM) releases its Purchasing Managers Manufacturing Index for June. Recent readings from this measure show inflation pressures for manufacturers have risen as activity in the sector remains weak. We will monitor it for signs of additional price pressures and the pace of growth in activity.

Tuesday: The BLS will release its Job Openings and Labor Turnover Survey report for May. We’ll watch for whether the gap between job openings and job seekers is continuing to narrow, which would help ease wage pressures for businesses. We’ll also keep an eye on the so-called “quits” rate to see if workers are feeling confident in their ability to find different or better jobs.

Wednesday: The ISM releases its latest Purchasing Managers Services Index. While the services side of the economy has been remarkably resilient, the pace of growth has slowed. We’ll be looking to see if this trend continues or has gained momentum. Another point of focus will be the measure of prices paid.

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 and looking to see if there was any divergence in opinion as to the possible timing of future rate cuts.

Challenger, Gray and Christmas Outplacement Services will release its report on announced job cuts and hires. This report has shown weak demand for workers this year, with hiring announcements running at the slowest pace year to date since 2012 (and before that, 2008). The report has also shown an increase in layoffs this year.

Thursday: Initial and continuing jobless claims will be out before the market opens. Continuing claims have been moving higher, and we’ll continue to monitor this report for signs of eroding strength of the employment picture.

Friday: The BLS will release the jobs report. We’ll be watching to see if the rise in the pace of job gains continued in June. Importantly, we will be monitoring the labor force participation rate and wage growth. A rise in labor force participation could help ease the current elevated wage pressures. However, if the participation rate holds steady or declines, wage pressures are more likely to persist.

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