Signs of Lingering Inflation Raise the Stakes for the Fed

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

Stocks finished lower last week amid more signs that the disinflationary process has stalled and price pressures have reemerged. Fixed income yields moved higher on the data, and market expectations for rate cuts this year eased. At the close of last week, the market was forecasting a total of 75 basis points in total cuts by the Federal Reserve in 2024, down from expectations of 95 basis points at the end of the prior week. In January market expectations called for 170 basis points in cuts for the year.

For the past several months we have used these commentaries to lay out the case for why the recent trend in inflation data may force the Federal Reserve to keep rates higher for longer. Likewise, we’ve noted that the longer rates are elevated, the greater the impact they will have on the economy. And that may lead to a mild recession. A look at recent data showing how much of consumers’ income is going toward higher interest rates may underscore the significant drag that elevated rates can have on households. Personal interest expenses on consumer debt (which excludes mortgage debt) was $277 billion annually at the time the Fed began raising rates in March 2022. Since then—and 525 basis points in hikes later—interest payments have grown to $573 billion as of January 2024, or more than double where they were when hikes started. That translates to $296 billion more that consumers (especially those on the lower end of the economic scale) are spending on interest as opposed to buying goods or services.

Mortgage debt service costs, however, have risen at a much slower pace. In March 2022, interest costs for mortgages were an estimated $460 billion and have since risen by 25 percent to $578 billion at the end of 2023. The slower pace of growth in mortgage servicing costs is due to the fact that the vast majority of mortgages in place at the time the Fed began raising rates had fixed rates and so did not reprice as the Fed funds rate rose. Should rates remain elevated for a sustained period, many of these mortgages will reprice as homeowners eventually move or take out home equity loans at higher rates. If that happens, even more of consumers’ budgets will go toward interest payments instead of feeding the economy.

Put simply, the longer rates remain elevated, the less consumers will be able to spend on buying goods and services, which we believe could lead to a mild recession. Unfortunately, data out last week did little to reassure members of the Federal Open Markets Committee that it could safely cut interest rates without jeopardizing its goal of bringing inflation down sustainably down to 2 percent.

Wall Street wrap

Data out last week bolstered the case that inflation pressures are moving higher and that the Fed faces a tough challenge in its efforts to prevent a recession while bringing inflation down sustainably to its 2 percent target.

Inflation moves higher: The latest Consumer Price Index reading from the Bureau of Labor Statistics showed that headline inflation increased in February by 0.4 percent compared to 0.3 percent in January. On a year-over-year basis, the headline figure was up 3.2 percent. Core inflation, which excludes volatile food and energy costs, rose 0.4 percent in February, unchanged from January’s pace, and is now up 3.8 percent on a year-over-year basis. A 0.4 percent rise in shelter costs was a key contributor to the increase in Core readings.

Goods inflation crept higher for the first time in eight months, with a modest rise of 0.11 percent in February. On a year-over-year basis, goods prices are down 0.3 percent. Conversely, the pace of service inflation remained elevated, up 0.44 percent in February and rising by 5.2 percent year over year. Although the year-over-year reading is well below the peak of 7.3 percent in February 2023, the trend is concerning. On a three- and six-month annualized basis, services prices are running at a pace of 6.1 percent and 5.8 percent annualized, respectively. As we’ve noted in the past, lagging shelter prices can skew the rate of the current inflation for services. Unfortunately, stripping out the lagging shelter reading doesn’t improve the picture. Excluding shelter, services prices were up 0.6 percent for the month and are up 3.9 percent year over year. Once again, the shorter-term trend shows cause for caution. On a three- and six-month annualized pace, services inflation excluding shelter comes in at 6.9 percent and 6.08 percent respectively, suggesting upward pressure in the coming months. For comparison, this measure was as low as 2.8 percent year over year as recently as September 2023.

Other inflation measures we follow reinforce our view that inflation is heading in the wrong direction. Indeed, the annualized reading of the Cleveland Federal Reserve’s inflation reading, called the Cleveland Median CPI, came in at 0.37 percent in February, translating to a 12-month annualized pace of 4.6 percent, lower than January’s reading of 6.5 percent—but this measure is also trending higher, climbing in fits and starts from a one-month annualized pace of 2.4 percent in July 2023.

Finally, the Atlanta Federal Reserve’s Core Sticky Consumer Price Index rose at an annualized pace of 4.3 percent in February. Over the past three months, this measure shows sticky inflation rising at an annualized rate of 5.1 percent after bottoming in July 2023 at a three-month annualized pace of 3.6 percent. Simply put, the trend suggests inflation readings are going the wrong way and are not on path to sustainably land inflation at 2 percent. These measures support our view that the underlying cause of inflation has shifted to being driven by factors typically seen late in a business cycle, when inflation becomes “stickier” and is harder to snuff out.

Costs for producers jump: Producer input final demand prices came in well above Wall Street expectations, rising 0.6 percent in February, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The latest monthly reading is up from January’s 0.3 percent rise. On a year-over-year basis, headline PPI is up 1.6 percent, the highest year-over-year pace since September 2023. Core PPI, which strips out volatile food and energy, was up 0.3 percent for the month, down from January’s 0.5 percent increase. Core PPI was up 2.0 percent on a year-over-year basis. The PPI measures price increases for finished goods leaving the factory.

Pessimism among small business owners rises: The latest data from the National Federation of Independent Businesses shows optimism among small businesses extended its streak of below-average readings to 26 consecutive months. Optimism declined in February to 89.4, down 0.5 points from January’s reading and well below the 50-year average of 98. Similarly, optimism over business conditions in the coming six months declined to a reading of a net negative 39 percent, a decline of 1 point from January. The latest economic outlook reading continues a streak of results at levels usually seen during or leading up to recessions.

The latest report shows inflation has taken over the top spot among respondents’ concerns, with 23 percent identifying rising prices as their primary concern. Concerns about labor quality eased in the latest report, although they remain a pressing issue for business owners. The latest data shows that 16 percent of respondents identified labor quality as their top concern, down five points from January. The downtick in those concerned about finding the right job candidates could be a reflection of changes in hiring plans. The latest survey shows that just 12 percent of businesses plan to hire in the coming three months, down two points from January and now at the lowest level since May 2020. With demand for new workers expected to fall in the coming months, so too has the number of businesses that have raised wages. A net 35 percent of small businesses reported raising wages during the past month (down two percentage points from January), and 19 percent plan to raise compensation in the coming three months, down seven points from January. To be sure, the number planning to raise pay is still historically high; however, it is a potential sign of encouragement that the pace of wage growth may slow should demand for workers continue to ease in the coming months.

As business owners continue to worry about inflation, 30 percent of those surveyed plan to raise prices in the next three months, down three points from January. While the portion of business owners planning to raise prices has moderated slightly in the past few months, it remains well above historic norms. Except for a few months in 2008 and a brief period in the 2004–2005 time frame, plans to raise prices have not been this high since the late 1970s–early 1980s during the wage–price spiral.

Consumer optimism holds steady: Consumer sentiment was little changed, moving to 76.5 in March, down 0.4 points from February’s final reading of 76.9, according to the latest consumer sentiment survey released by the University of Michigan. Respondents remain confident that inflation will continue to fall, the labor market will remain strong, and interest rates will be moving lower. Since the Federal Reserve’s December meeting, the interest rate expectations index has shot up from 57 to the latest report’s reading of 100, which reflects expectations for lower rates; indeed, this is at levels normally consistent with aggressive rate cuts and lower interest rates post-recessions. Absent a recession, we believe rate cuts will be modest at best in the coming months.

Results from the survey show that inflation expectations remain well anchored, with respondents anticipating prices rising 3 percent in the coming year, unchanged from the prior month. Long-term inflation expectations held steady at 2.9 percent for the fourth straight month. For context, long-term inflation expectations have fallen in a range of 2.9 percent to 3.1 percent in 28 of the past 31 months.

The survey also showed that November’s presidential election was beginning to weigh on respondents’ minds. According to the latest release, 19.4 percent of consumers spontaneously mentioned elections, with most comments made in the context of economic prospects being influenced by election results. The percentage of people mentioning the election is higher than the 16.4 percent who mentioned elections in March 2020 (16.4 percent) and March 2016 (18 percent). But remember—as we noted in a recent article, while presidential administrations can nudge the economy in one direction or the other, there are other factors that play a much larger role in the path of the economy.

Consumer spending bounces back: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in February rose by 0.6 percent, up from January’s revised decline of 1.1 percent. The latest report shows retail sales are up 1.5 percent on a year-over-year basis. Nine of 13 categories measured saw increases, led by nonstore retailers and food services and drinking places. The latest uptick in spending comes on the heels of January’s unexpectedly weak retail sales report. Consumer spending has been a source of strength for the economy, and we will be watching this report to see if the latest rebound is a temporary blip or a resumption of consumers’ willingness to open their wallets.

Continuing jobless claims rise: Weekly initial jobless claims were 209,000, down 1,000 from last week’s downwardly revised figure. The four-week rolling average of new jobless claims came in at 208,000. Continuing claims (those people remaining on unemployment benefits) stand at 1.811 million, an increase of 17,000 from the previous week’s revised total. The four-week moving average for continuing claims rose to 1.799 million, up 2,000 from last week’s upwardly revised figure.

The week ahead

Monday: The Homebuilders Index from the National Association of Home Builders will be out mid-morning. Confidence among builders has risen recently as mortgage rates have eased and builders expect lower rates in the year ahead. We will be watching to see if uncertainty about the timing of rate cuts has had an impact on homebuilders’ optimism.

Tuesday: We will get February 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 that a modest pullback in mortgage rates is having on new home construction.

Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following its monthly meeting. This meeting will also include updated economic and interest rate forecasts from members of the Federal Reserve Open Markets Committee. We expect the Fed will hold rates steady, and we will be listening for forward guidance on the path and timing of rate changes going forward. We will also be listening to comments on the current state of the employment picture and wages.

Thursday: 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 March. Activity in manufacturing strengthened in recent surveys and has crossed into expansionary territory, while the services side has shown continued resilience. We will be watching for signs to determine whether both sides of the economy have seen an uptick in price pressures. We’ll also be paying close attention to demand for employment in both industries.

Initial and continuing jobless claims will be out before the market opens. Initial filings were up modestly last week, and the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

The Conference Board’s latest Leading Economic Index survey for January will be out mid-morning. For months, these reports have suggested the U.S. economy may be on the cusp of or is in a recession. The data improved modestly again last month, and we will be watching to see if the uptick has become a trend.

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 improvement continue in the face of modestly lower mortgage rates.

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