More Encouraging News on the Inflation Front

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

Economic data out last week suggest the march toward easing price pressures and a slowing economy continues. The latest Producer Price Index (PPI) from the Bureau of Labor Statistics showed input costs for finished goods were up 0.2 percent in October on a seasonally adjusted basis, lower than Wall Street expectations of 0.4 percent. Year over year, prices were up 8 percent in the latest reading, down from September’s level of 8.4 percent. While still elevated by historical standards, the latest reading is a significant improvement from the recent high of 11.7 percent registered in March of this year. Noteworthy in the report was an outright decline in the costs service providers faced. October’s reading marked a decline of 0.1 percent and was the first-time costs have fallen since November 2020, when the services side of the economy was still largely shuttered due to COVID.

Costs for goods manufactured edged up 0.6 percent in October compared with an increase of 0.3 percent in September. However, when stripping out volatile energy and food prices, input costs for finished goods declined 0.1 percent for the period. While not as widely heralded as the Consumer Price Index (CPI), PPI is important because the cost pressures faced by producers of goods and services are generally passed on to consumers and therefore have an impact on backward-looking measures (such as CPI and the Personal Consumption Expenditure index).

The latest readings for services input costs is particularly encouraging because it suggests that the services side of the economy is following the path laid out by manufacturing. As we’ve previously noted, demand for goods peaked during the heart of the COVID pandemic, and since then, consumer spending has migrated to the services side of the economy. Consequently, inflation has followed the same path, with price pressures for goods ebbing while the services side has seen increased inflation. The latest PPI data reaffirms our belief the price pressures on the services side are poised to cool, and additional data out of the housing sector last week suggests the pace of declining price pressures in services could gain momentum.

The National Association of Realtors reported that existing home sales in the U.S. dropped 5.9 percent to a seasonally adjusted annual rate of 4.43 million units in October. Excluding a brief decline early in the pandemic, this is the lowest level since December of 2011. It also marked the ninth straight month of falling sales. On the supply side, single-family homebuilding and permits for future construction fell to the lowest levels since May 2020, while housing inventory fell 0.8 percent to 1.22 million units. With both demand cooling and supply dropping, prices have remained relatively unchanged at current levels.  However, digging into the numbers from the National Association of Realtors reveals that while 24 percent of the homes sold in October were above asking price, homes unsold after 120 days saw prices reduced by an average of 15.8 percent. The discounting is a sign that buyers are becoming picky and are no longer rushing to buy what they view as sub-optimal homes out of fear that prices will continue to climb. Should this trend continue, we expect housing prices could soften further in the months ahead.

New housing starts fell again in October to the lowest level in more than two years as home builder sentiment continues to fall. The new construction data fit with the latest report from the National Association of Homebuilders showing builder confidence dropped for an 11th straight month in November, coming in at 33 — the second-worst level since June 2012. For context, sentiment was at 84 to begin the year (readings of 50 or above indicate expansion). The easing in demand has led to an uptick in concessions from builders, including price cuts and mortgage rate buy-downs.

As a reminder, housing has a significant weighting on services inflation as measured by CPI, and there is as much as a 12-month lag time for moderating housing costs and rents to filter into the CPI reading. Given that rent increases peaked in February and a rapid unwinding of housing prices during the past few months, we believe significant improvements in the inflation rate for shelter are on the near horizon. This latest data suggest the decline in shelter price pressures is poised to continue.

Last week’s PPI and housing data, when viewed alongside the lower-than-expected CPI reading released earlier this month, has raised expectations that the Federal Reserve will reduce the size of future rate hikes and may have room to pause the hiking cycle altogether in the coming months. Perhaps sensing that the data was beginning to loosen the Fed’s hold on the narrative for the need for continued hawkish moves, several board members of the Federal Reserve’s Open Markets Committee (FOMC) took to the airwaves to tamp down talk of a less aggressive path forward on rates.

James Bullard, president of the Federal Reserve Bank of St. Louis, sounded a particularly hawkish tone, saying that the Fed funds rate may have to rise to a level between 5 and 7 percent — up from its current level of 3.75 to 4 percent — in order to effectively fight inflation. Other board members, such as Susan Collins from the Boston Fed, noted that more work needed to be done but also suggested that there may be a path to rein in inflation without causing a significant spike in job losses. We view these comments as the Fed continuing to talk the economy into submission in hopes that it won’t need to cause long-term damage by raising rates too far. Should backward-looking jobs data begin to falter, we believe members of the FOMC will pivot in unison to a less aggressive stance toward rates. As we’ve noted in previous commentaries, forward-looking indicators suggest that the strength of the labor market has become brittle, and we expect it to weaken meaningfully in the coming months.

Wall Street Wrap

While much of the data last week pointed to progress in the fight against higher prices, some additional reports highlight that easing inflation and slowing demand are likely to be felt unevenly throughout the economy.

Mixed bag for retailers: The latest numbers from the U.S. Commerce Department show retail sales rose 1.3 percent in October above consensus estimates. However, a significant portion of the uptick was driven by a jump in gas prices. While the overall numbers were strong, many major retailers have reported this earnings season that shoppers are holding out for discounts and refusing to pay full price. The willingness to delay purchases until goods go on sale could bode well for the direction of inflation. As the Fed has frequently noted, consumer expectations are an important element as to whether upward price pressures can take hold. If consumers expect prices to continue to climb, they would forgo waiting for sales out of fear that the costs of buying later would be markedly higher. 

Recession risks increase: The Conference Board’s latest Leading Economic Index (LEI) dropped 0.9 percent in October and is now down 6.4 percent on an annualized basis over the past six months. The latest reading marks the eighth consecutive month of declines and may point to the U.S. economy already being in recession. For context, each time during the past 63 years that LEI readings have been at the levels we are seeing today, the economy has either been in or on the verge of a recession. As we’ve noted in the past, we don’t believe inflation will be able to withstand a recession. While we believe a recession is approaching, we continue to believe it will be mild and uneven given the overall financial strength of U.S. consumers, banks and corporations.

The week ahead

It’s a short week for Wall Street, but some important data will be released, with Wednesday seeing the bulk of the reports.

Monday: The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures. This report should provide further insights as to whether softening of the U.S. economy has accelerated.
Wednesday: 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 November. Activity for both manufacturing and services has weakened in recent months. Likewise, cost pressures have been easing for manufacturers as inventories have been rebuilt and supply chain bottlenecks have cleared. We will be watching for signs that the trend of ebbing costs is broadening into the services side of the economy.

The final numbers for the University of Michigan Sentiment survey will be released. Initial readings related to long-term inflation expectations edged up slightly in the latest preliminary reading, and we will be watching for downward revisions to that reading. Inflation expectations remain an area of focus for the Federal Reserve as it contemplates future rate hikes. We will also be watching for any fine-tuning of consumer sentiment readings given the pessimistic outlook captured in the preliminary numbers.

Thursday: Happy Thanksgiving!

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