Inflation Remains Too Hot for a Goldilocks Economy

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

Over the past several months, we’ve detailed the evolving forces that have contributed to inflation pressures for the past few years and used data to illustrate progress in unwinding each of these phases. Unfortunately, some of the nuance of this approach seems to have fallen by the wayside among those who are increasingly convinced that we are on the cusp of a soft landing. Instead of focusing on the many contributors to inflationary pressures—including wages—many point to the direction of inflation readings and place far less emphasis on the actual current drivers of price pressures.

That’s why we were heartened to hear last week from John Williams, New York Federal Reserve president and vice president of the Federal Open Market’s Committee, with comments that attempted to refocus the discussion about the economy and inflation—not just on the direction of price pressures but also on the various factors that contribute to inflation. In a speech in White Plains, New York last week, Williams likened factors that contributed to inflation following the arrival of COVID to layers of an onion, each layer giving way to another driver of elevated prices. The outermost layer was driven by commodity price spikes during the early days of COVID and made worse by the Russia invasion of Ukraine. Next up was a surge in demand for goods at a time when supply chains were snarled, resulting in demand far outstripping supply. The final, innermost layer of the inflation puzzle—and one that still exists today—was the spike in core services inflation, which resulted from pent-up demand for experiences that was unleashed as COVID lockdowns faded.

Regular readers of our Weekly Market Commentary will know that our view of the drivers of post-COVID inflation lines up well with Williams’s analysis. We also agree with Williams’s assessment that the first two “layers” of inflation have dissipated—at least for now. However, we find ourselves at odds with his assessment on what he identifies as core services inflation. Much as we did last year, Williams noted the slowing of shelter inflation as a positive factor in bringing services inflation down. However, we believe the current data (as spelled out in our Consumer Price Index discussion later in this piece) shows that services inflation remains relatively sticky.

Williams went on to identify three indicators that are useful in assessing the future of price pressures: 1) inflation expectations, which he rightfully pointed out remain anchored; 2) the New York Federal Reserve’s Multivariate Core Trend (MCT) inflation reading, which is trending down (however, other predictive measures of inflation are painting a different picture); and 3) wage growth. On the wage front, we believe recent data shows that growth continues above levels consistent with 2 percent inflation and, based on employer plans, are unlikely to slow in the near term.

We acknowledge that the pace of services inflation has eased over the past few months and is markedly below recent highs. However, wage growth, which is a key component of services inflation, remains elevated at 4.3 percent year over year. That’s well above the 3 to 3.5 percent range we believe is necessary for the Fed to achieve its goal of 2 percent annual inflation. Additionally, in the latest results of the National Federation of Independent Business (NFIB) survey, 36 percent of employers reported raising compensation. Unchanged from November, a seasonally adjusted net 29 percent of business owners plan to raise compensation in the coming six months, up from a nearer-term low of 21 percent in July. In data going back to 1984, we have seen this level exceeded only during a few months shortly after COVID began, and not surprisingly, this has a correlation with actual wage growth. As we illustrated in our latest Quarterly Market Commentary, historically there has been a strong relationship between business owners’ plans for raising compensation and the pace of wage growth going forward. Put simply, these latest readings suggest wage pressures are unlikely to dissipate in the near term.

Similarly, details of inflation data out last week, including the latest reading of the Consumer Price Index, point to the disinflationary process stalling, in part due to still elevated services costs. As such, we continue to expect the Fed to take a higher-for-longer stance on rates, which will ultimately lead to a mild and short-lived recession in the coming months. Fortunately, with two of the three elements behind the post-COVID inflation spike largely controlled and inflation expectations still anchored, the Fed should have room to cut rates to shorten and soften the blow of an economic contraction.

Wall Street wrap

Below we take a deeper dive into the data to explain why we believe factors from wages to inflation may force the Fed to keep rates higher for longer. Additionally, we look at some of the latest readings that suggest the economy is likely to struggle in the coming months.

Inflation and the employment picture weigh on small business owners: The latest data from the NFIB shows optimism among small businesses extended its streak of below-average readings to 24 consecutive months. While optimism improved modestly in December to 91.9 (up 1.3 points from November), the reading remains well below the 50-year average of 98. Similarly, optimism over business conditions in the coming six months remains decidedly weak and is still at recessionary levels despite a six-point improvement to a net negative 36 percent.

Despite the modest improvement in outlook, the overall outlook of business owners remains dour. “Small business owners remain very pessimistic about economic prospects this year,” said NFIB Chief Economist Bill Dunkelberg in a statement accompanying the results. “Inflation and labor quality have consistently been a tough complication for small business owners, and they are not convinced that it will get better in 2024.”

Indeed, inflation is the top worry for respondents (followed by labor quality), with 23 percent citing it as their primary concern. Likewise, 40 percent of respondents reported having job openings they struggled to fill, and 89 percent of those hiring reported challenges in finding qualified candidates. Staying on the inflationary pressures front, 32 percent of small business owners plan to raise prices in the next three months. That’s down from November’s level of 34 percent but still well above the reading of 21 percent in April. Similar to the changes in compensation, plans to raise prices had been falling since early 2022 and bottomed in April of this year. For further context, except for a spike following COVID, we’ve only reached these levels a few times since the inflationary era of the late 1970s and early 1980s. Not surprisingly, price increase plans result in actual price increases and are another way a wage-price spiral evolves.

Given the generally pessimistic view business owners have of the economic climate, just 24 percent expect to make capital outlays in the coming months. This figure is important because capital outlays are a key component to improving productivity. As noted in a release accompanying the survey results, “A recovery in investment is needed to support an improvement in productivity, but this is unlikely to occur while owners remain pessimistic about future business conditions and lending standards tighten with high interest rates. Longer term, the worker shortage has given firms an incentive to invest in labor-saving technology. But overall, capital spending is not strong historically.” As we’ve noted in the past, a surge in the labor pool or a rapid increase in productivity of the current workforce that allows existing workers to create more output per hour could alleviate further inflation pressures. The fact that small businesses are reluctant to invest in capital outlays makes a boom in productivity far less likely in the near term, as the levels in the latest NFIB survey are well below those seen prior to the productivity boom of the mid to late 1990s.

Inflation moves higher: The latest CPI reading showed that headline inflation increased in December and came in higher than Wall Street expectations. Headline inflation rose 0.3 percent in December and was up 3.4 percent on a year-over-year basis. The monthly increase was up from 0.1 percent in November and 0.0 percent in October. Core inflation, which excludes volatile food and energy costs, rose 0.3 percent in December, unchanged from November’s pace, and is now up 3.9 percent on a year-over-year basis. Highlighting the stuck nature of core inflation on a seasonally adjusted basis, the three-, six- and nine-month annualized readings of the measure are all in the low to mid-3 percent range.

Services inflation, which Williams identified as the third layer of inflation, rose 0.4 percent for the month and is up 5.3 percent year over year. Admittedly, shelter costs, which have slowed but are once again moving higher, are boosting the overall services reading. However, when these costs are stripped out, services (excluding rent of shelter) prices were still up 0.6 percent in December, on the heels of a 0.6 percent increase in November. This puts the year-over-year pace at 3.4 percent, which is down from the prior month’s 3.5 percent but is trending higher than readings from June to October of 2023, when they were in the low 2 to 3 percent range. Digging deeper, so-called “super core” services inflation rose 0.4 percent in December, little changed from November’s increase of 0.44 percent. On a year-over-year basis, super core inflation is up 3.91 percent.

To be sure, not all data in the latest report showed persistent price pressures. Goods inflation was flat in December after six consecutive months of declines in the cost of goods. On a year-over-year basis, the cost of goods is up just 0.2 percent, and we expect it will remain subdued in the near term.

In New York Fed President Williams’s speech, he pointed to the New York Fed’s MCT inflation reading as an indicator of future inflation that points to easing price pressures. However, other measures that capture price trends confirm that the disinflationary process appears to have stalled. Indeed, the annualized reading of the Cleveland Federal Reserve’s inflation reading, called the Cleveland Median CPI, came in at 4.8 percent annualized, lower than November’s reading of 5.3 percent but well above October’s reading of 3.9 percent. Simply put, the trend suggests work remains to bring the inflation rate down to the Fed’s target of 2 percent. 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.

The point of this deep dive into various inflation readings is to show that while price pressures are well off their post-COVID highs, they remain well above the Fed’s target of 2 percent, and the disinflationary process appears to have stalled. As such, we continue to believe the Fed is unlikely to lower interest rates until the pace of wage growth and inflation eases, which most likely will be caused by greater slack in the employment market.

Continuing jobless claims ease: Weekly initial jobless claims numbered 202,000, a decrease of 1,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 207,750. Continuing claims (those people remaining on unemployment benefits) were at 1.834 million, a decrease of 34,000 from the previous week. The four-week moving average for continuing claims declined slightly to 1.862 million, down 8,000 from last week’s upwardly revised figure.

The week ahead

Tuesday: The Empire State Manufacturing Index, released before the opening bell, will offer a look at the health of manufacturing and general business conditions in the influential New York state region.

Wednesday: The U.S. Census Bureau will release the latest numbers on retail sales for December before the opening bell. We will be watching to see the final reading on holiday spending.

We’ll get a look at the manufacturing side of the economy with the release of the latest industrial production figures from the Federal Reserve. Consumer spending has been a source of strength in the economy, while manufacturing has been weak. We’ll be watching to see if this report shows a continued trend of industrial production languishing.

The Federal Reserve will release data from its Beige Book. The book provides anecdotal insights into the nation’s economy and has shown economic weakness in many parts of the country as of late. We will be watching to see if this trend continues.

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

Thursday: We will get December 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 the impact still-elevated rates are having on new home construction.

Initial and continuing jobless claims will be announced before the market opens. Initial filings were up again, and the four-week rolling average of continuing claims reached a two-year high. We will continue to monitor this report for sustained signs of changes in the strength of the employment picture.

Friday: The University of Michigan will release its preliminary report on January consumer sentiment and inflation expectations. We will be watching to see if a recent uptick in consumer confidence and easing inflation expectations are continuing into the new year.

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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