Latest Economic Data Underscores the Fed’s Tough Task Ahead

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

Positive earnings news from several companies last week helped offset more evidence that rate cuts are likely off the table through the summer and potentially longer. While the major indices posted gains for the week thanks to strong quarterly results form a few mega-cap stocks known as the “magnificent seven,” other data out last week, such as the initial estimate of first-quarter gross domestic product (GDP) growth from the Bureau of Economic Analysis, further drove the point home that the inflation is going in the wrong direction, and the economy remains too strong for the Fed to reduce rates in the near term. And while the GDP report received the most attention, a comprehensive report from the Bureau of Labor Services, also out last week, highlighted the incredibly difficult task the Federal Reserve faces in snuffing out inflation without causing a recession.

As we’ve noted over the past several months, the Fed is focused on the job market and wage growth because of the role wages can play in feeding a wage–price spiral. A tight job market usually results in higher wages, and those higher wages can be used to pay higher prices, which then encourages even more inflation. Unfortunately, given that employment is a lagging indicator of the economy, when signs of weakness finally do appear in the labor market, it is often after a decline in the economy is already in motion and downside momentum can build quickly. Last week’s Business Employment Dynamics (BED) report highlights how, despite headline employment data suggesting a robust job market, there are underlying signs that things may be more brittle than they appear.

The BED report comes out quarterly and covers 9.1 million private businesses across the country compared with just 670,000 included in the monthly nonfarm report from the Bureau of Labor Statistics (BLS). The latest report looks at the employment picture for the third quarter of 2023. The larger sample size and the fact that it is a quarterly report make it less susceptible to the type of material revisions that can occur in the nonfarm data. This distinction is worth highlighting because the BED data suggests we may see meaningful revisions to what were viewed as strong nonfarm numbers reported over the past few quarters. As a reminder, the household report, which is released at the same time as the nonfarm data, has shown a much softer employment picture than the nonfarm report.

The latest quarterly report shows that 192,000 jobs were lost in the third quarter of last year. Conversely, nonfarm reports covering the same period showed job gains of 494,000. The BED data also shows that job losses were spread throughout the economy, with eight of 13 industries reporting decreases. Additionally, gross job losses outpaced job gains in 35 states. Taking it a step further, the latest data shows that 18 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 has 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. While the national unemployment rate is not yet at the threshold identified by the Sahm rule, it’s noteworthy that 36 percent of the states are.

The BED report is consistent with other employment indicators we follow. For example, three of the last four employment readings from the Institute for Supply Management (ISM) PMI Index for both manufacturing and services have shown declining employment readings. Since 1997, there have been 44 months in which both groups reported declines in employment. In 41 of those 44 instances (93 percent), the nonfarm payroll report also showed job losses. And finally, the Employment Trends Index from the Conference Board also points to a weakening labor market. The index is an aggregate of eight labor market indicators and is a forward-looking measure. The index has been on a downward trajectory since March 2022, although month-to-month readings have bounced around.

The point of this detailed dive into various employment indicators is to highlight that the margin between what appears to be a strong job market and one that could unravel quickly is thin. As such, we continue to believe that despite the Fed’s best efforts to the contrary, it is unlikely the Fed will be able to avoid a recession as it continues to battle stubborn price pressures.

Wall Street wrap

While corporate earnings and GDP numbers took center stage last week, several other reports highlight that, while still growing, the economy may be less robust than many believe.

Higher inflation and solid growth: The initial estimate of first-quarter GDP growth from the Bureau of Economic Analysis was a bit of a “tale of two cities.” While the headline number of the 1.6 percent quarter-over-quarter seasonally adjusted annualized rate came in lower than Wall Street expectations and was much slower than the previous quarter’s final reading of 3.4 percent, a deeper look at the data suggests the economy continues to expand at a solid pace. Two key areas that dragged the headline number down were inventories and trade imbalances. Combined, these two items shaved nearly 1.2 percentage points from headline GDP. However, given the volatility of those categories it is useful to look at final sales to domestic purchasers to get a better gauge of overall activity. This less volatile measure was up 2.8 percent at a seasonally adjusted annualized rate. Consumer spending continued to prop up growth, with consumers seeing 2.5 percent annualized growth and contributing 1.68 percent to the headline GDP reading. While the growth story told by the GDP numbers is positive, the inflation data included in the report is decidedly less encouraging.

The GDP report shows that the Personal Consumption Expenditures (PCE) index rose by 3.4 percent at an annualized rate in the first quarter compared to a 1.8 percent increase for the previous quarter. Core PCE, which excludes food and energy, was up 3.7 percent, marking the highest level since the second quarter of 2023. For context, core PCE came in at 2 percent in the fourth quarter of 2023—clearly things are moving in the wrong direction. PCE is the Federal Reserve’s preferred measure of inflation, and the pace of inflation captured by the report has been slower than the more widely reported Consumer Price Index (CPI). This discrepancy had some holding out hope that the disinflationary process was still intact and that the Fed would be able to cut rates as a result. However, this quarterly reading suggests that the PCE measure is starting to show the same trajectory for rising prices as has been recorded by the CPI measure.

More on inflation: The latest PCE reading from the Bureau of Economic Analysis showed that headline inflation rose 0.3 percent in March, the same pace as in February and above Wall Street estimates. On a year-over-year basis, headline PCE stands at 2.7 percent, up from 2.5 in February. Core PCE, which strips out volatile food and energy prices, rose 0.3 percent in March, unchanged from February’s pace. On a year-over-year basis, core PCE stands at 2.8 percent, unchanged from the prior month.

The cost of goods rose 0.1 percent in March, down from February’s reading of 0.5 percent and resuming a trend of goods inflation coming in lower than that of services. Services prices rose by 0.4 percent, up from February’s 0.3 percent pace. On a year-over-year basis, inflation for services crept higher to 4 percent, up from February’s upwardly revised reading of 3.9 percent. Goods prices are up 0.1 percent, compared to a decline of 0.2 percent in February. This is the first time year-over-year prices for goods have risen since December 2023. The latest PCE data fits with recent trends we’ve been seeing in prices. On a three- and six-month annualized basis, services inflation is running at a pace of 5.6 percent and 4.4 percent, respectively. Even when removing lagging shelter and focusing on core services, the inflation data shows an upward trend, with so-called “super core” services (which exclude shelter and energy) rising 0.4 percent for the month and up 3.5 percent year over year. On a three- and six-month annualized basis, super core inflation is up 5.5 percent and 3.8 percent, respectively. We believe this is too hot for the Fed’s comfort.  

The continued stubbornness of inflation is also captured in the Dallas Federal Reserve’s Trimmed Mean PCE, which removes outliers that can distort traditional PCE readings. According to the latest data, the six-month annualized pace of inflation is 3 percent, down from February’s reading of 3.2 percent but still well above the Fed’s target of 2 percent. Additionally, 55 percent of the components used to measure inflation saw increased prices. For context, at the end of 2023, that level was in the low 40-percent range.

Business activity slowed: U.S. business activity slowed in April and hit a four-month low. The latest preliminary data from the S&P Global Composite Purchasing Managers Index, which tracks both the manufacturing and service sectors, shows that the Composite Output Index reading came in with a reading of 50.9 (levels above 50 indicate growth), down from March’s final reading of 52.1

While technically still in expansion territory, the reports signaled growth broadly stalled, with an overall decline in new orders for the first time in six months. Some respondents in the services sector attributed declines in demand to higher interest rates and inflation. Manufacturers singled out higher prices and customer inventories already at acceptable levels.

The weak start to the quarter weighed on confidence among those surveyed, and business sentiment dipped to a five-month low. As business prospects dimmed, companies held back on replacing workers who had left. The pullback in hiring led to the first decline in employment since June 2020. Service providers reported the biggest declines in employment, with the size of the latest pullback rarely seen in the past two decades. In a statement released with the preliminary data, Chris Williamson, chief business economist at S&P Global Markets Intelligence, noted, “The more challenging business environment prompted companies to cut payroll numbers at a rate not seen since the global financial crisis if the early pandemic lockdown months are excluded.”

On the inflation front, the pace of rising input costs remains elevated but off from the six-month high recorded in March. It’s worth noting that price pressures have been greater for manufacturers of late than on the services side of the economy. This may further frustrate the Federal Reserve’s inflation-fighting efforts, as declines in the price of goods have been the primary source of disinflation over the past year. Should input costs stay elevated for manufacturers, it may spell an end for declines in goods prices. Furthermore, if costs for companies continue to rise while demand is falling, more businesses may need to turn to job cuts to maintain current profit levels.

Continuing jobless claims decline: Weekly initial jobless claims were 217,000, a decline of 5,000 from last week’s figure. The four-week rolling average of new jobless claims came in at 213,250, down 1,250 from the previous week’s average. Continuing claims (those people remaining on unemployment benefits) stand at 1.781 million, a decrease of 15,000 from the previous week’s downwardly revised total. The four-week moving average for continuing claims rose to 1,794,000, down 7,250 from last week’s downwardly revised figure.

The week ahead

Tuesday: The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work. We will also be watching to see if expectations for the economy and interest rates have been affected by recent inflation readings and the likelihood that the Fed won’t begin cutting rates until later this year at the earliest.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher in the past few months. We will be looking to see if home prices continue to rise despite elevated interest, which could lead to higher inflation readings several months from now.

The U.S. Census Bureau will release data on new home sales for March. We’ll be looking at this data to assess the impact the recent uptick in inflation and fluctuations in mortgage rates have had on demand for newly built homes. 

Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following its monthly meeting. We expect the Fed will hold rates steady, and we will be listening for forward guidance on the path and timing of rate changes. We will also be listening to comments on the current state of the employment picture and wages.

The manufacturing sector will be in focus as the Institute for Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index. Recent readings show inflation pressures for manufacturers have risen as activity in the sector has perked up. We will monitor it for signs of additional price pressures and the pace of growth in activity.

The BLS will release its Job Openings and Labor Turnover Survey report for March. We’ll watch for whether the gap between job openings and job seekers is continuing to narrow, which would help ease wage pressure 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.

Thursday: Initial and continuing jobless claims will be out before the market opens. Initial and continuing claims were down last week.  We’ll continue to monitor this report for signs of changes in the 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 April. 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.

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 Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumer credit card debt has risen in recent months, but overall balance sheets have remained manageable.

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