The Fed’s Next Move May Rest on How It Defines “Normal”

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

The strong start to the year for equities continued last week as new data added to the growing body of evidence that COVID-induced inflation is quickly fading. The latest release of the Consumer Price Index (CPI) showed headline inflation down 0.1 percent in December and now at 6.5 percent year over year compared to a November reading of 7.1 percent. Core inflation (which excludes volatile food and energy prices) was up 0.3 percent for the month, in line with expectations, and now stands at 5.7 percent year over year, down from November’s reading of 6 percent. Perhaps more instructive as it relates to the direction of inflation is the breakdown of price increases between goods and services.  

As we’ve noted in previous commentaries, demand for goods spiked in the early stages of COVID as supply chain bottlenecks developed and factories were shuttered to prevent the spread of the virus. Increased demand and diminishing supply led to year-over-year price hikes for goods reaching 12.3 percent in February 2022 — up dramatically from just 1.7 percent in March 2021. Since the highs of early 2022, demand for goods has eased significantly, as has inflation in the sector. The latest CPI report shows that prices for goods fell 0.3 percent in December, continuing a trend that began at the end of the third quarter of 2022, when price hikes stalled. Since that 0 percent reading in September, costs for goods have declined in each of the past three reports, with October’s prices down 0.4 percent and November seeing a decline of 0.5 percent. Strikingly, year-over-year goods inflation is now just 2.1 percent, which notably is in line with the Federal Reserve’s stated target inflation rate of 2 percent. With recent data showing the goods side of the economy facing shrinking demand and rebuilt inventories, we believe price pressures for the group are likely to remain subdued for the foreseeable future.

Although the goods side of the inflation equation has largely been solved, work remains to be done on the services side. The latest data show prices for services are up 7 percent year over year. It's worth noting, however, two factors are contributing to the elevated levels. First, the services side of the economy remained shut down in response to COVID longer than that of goods manufacturers. As a result, the recovery started later and as goods spending shifted toward experiences such as travel and restaurants. As a result of the spending shift, services prices began to climb. Second, and more important, shelter has a large and lagging effect on inflation readings in services (shelter accounts for 33 percent of the total CPI measure and has a 12-month lag). The latest CPI reading shows shelter was up 0.8 percent month over month in December and is 7.5 percent higher during the past 12 months. The uptick in shelter accounted for the bulk of the monthly increase; however, rent increases peaked in early 2022, and we have seen a significant downturn in housing prices beginning in late summer 2022. When the lagging shelter reading is stripped out of the equation, the remaining 67 percent of the economy (all-in CPI less shelter) used to calculate the rise in prices actually fell modestly during the past six months. As such, we believe that as the improving trend in shelter begins to seep into the overall inflation reading, price pressures for services should ease significantly in the coming months.

The steady improvement in price pressures has kept consumer expectations of long-term inflation well anchored. According to the latest reading of the University of Michigan Sentiment Survey, consumers expect prices to increase by 4 percent in the next year — well below the 5.4 percent rate recorded by the survey in March 2022. More importantly, expectations of inflation in the five- to 10-year range remain well anchored at just 3 percent. Inflation expectations are important as one of the things watched by the Fed as it strives to control price pressures. The Fed is concerned that if intermediate inflation expectations become elevated, inflation will become embedded in the economy as consumers negotiate wages differently and try to beat the pace of rising prices by purchasing products before costs move higher, thus fueling an upward spiral of continually rising inflation.

While we believe the data out last week provide added cause for the Fed to downshift on its path to higher rates, the ultimate decision may hinge on how members of the Federal Open Markets Committee define “normal.” Will it be based on the period following the end of the Great Financial Crisis (GFC) in 2009 through the beginning of the global pandemic, a period marked by inflation that was persistently below 2 percent (which the Fed considered to be “too low”) or will it be based on the years prior to 2007, when inflation was well controlled but also often above 2 percent?

It’s important to note that it was less than three years ago when Fed Chair Powell announced at the 2020 Jackson Hole Economic Symposium that the Fed wouldn’t tighten interest rates until conditions reached maximum employment and inflation was on track to moderately exceed 2 percent. Powell described the policy as “average inflation targeting.” Essentially, the goal was to shock the economy out of the deflationary malaise that it had been stuck in for much of the decade that followed the GFC. The Fed reasoned that by allowing inflation to run moderately above 2 percent for some time, inflation expectations and inflation would rise, which would alleviate the risk of a deflationary spiral.

When unveiling the policy, Powell said, “Many find it counterintuitive that the Fed would want to push up inflation,” but that “inflation that is persistently too low can pose serious risks to the economy.” He further noted the importance of “an unwelcome fall in longer-term inflation expectations, which, in turn, can pull inflation even lower, resulting in an adverse cycle of ever lower inflation and inflation expectations” — which would leave policymakers with little room to lower rates during economic stress.

A look back to Powell’s comments at the 2020 symposium is important in light of several comments out last Friday from market watchers. While the latest release of the University of Michigan Sentiment Survey shows nearer-term inflation expectations declining, these market watchers point out that the five- to 10-year figure of 3 percent remains above the 2.2 to 2.6 percent range it was in the years immediately preceding the pandemic and, therefore, could be viewed as too high by the Fed. We believe this analysis is flawed and that if expectations receded to the lower range, it could mark a return to fears of deflation — the exact battle the Fed was waging two and a half years ago. Ironically, current expectations of 3 percent are more consistent with the years prior to 2007, when inflation was considered normal. This is why we believe that should the Fed go too far with rate hikes, it may unwind what it was trying to accomplish pre-COVID: higher inflation expectations.

With inflation expectations at healthy levels and current inflation continuing to fall, we believe the Fed needs to slow the pace of rate hikes and contemplate the ramifications of continuing on an aggressive path. The Fed, in our view, needs to recognize that risks of its policy actions are increasingly becoming two sided as opposed to focusing simply on what we believe are waning risks of elevated inflation. We believe it must also consider the likelihood of a return to a deflationary environment if it does go too far and continues to tighten policy. 

We believe that with inflation likely to continue its decline, inflation expectations currently anchored at normal levels and employment growth poised to slow, the Fed needs to soften its stance on future rate hikes or risk a return of the threat posed by deflation to the U.S. economy. Additionally, should the Fed’s actions cause a significant jump in unemployment, we believe there is a risk that many of the workers who are out of jobs may leave the labor market permanently, which could lead to lower long-term U.S. economic growth rates by inflaming labor market shortages.

Put simply, the risk of doing too little needs to be balanced now with the growing risks of doing too much.

Wall Street Wrap

While the headlines were largely focused on the latest year-over-year decline in CPI, other reports suggest that the threat of a reawakening of inflation in the coming months remains low.

Subdued consumer optimism: The latest results from the University of Michigan Sentiment Survey show consumer optimism continues to creep higher at 64.6 but remains consistent with levels typically seen during recessions. In June 2022, sentiment reached 50 — the lowest level since the introduction of the survey in 1978. Not surprisingly, the trend of improving outlook coincides with months of improving inflation data.

Despite recovering from the depths reached in the middle of last year, consumers remain concerned about the threat of a recession, with two-thirds of respondents expecting an economic downturn in the year ahead. Additionally, 41 percent of those surveyed expect the labor market to weaken over the next five years. Given the level of concern about the future, we believe consumer purchasing behavior could be subdued in the months ahead, which will continue to keep a lid on pricing power for both goods and services.

Independent businesses feeling inflation relief: The latest data from the National Federation of Independent Business show that inflation pressures continue to ease, with the percentage of owners raising selling prices falling from 66 percent early in 2022 to just 43 percent in December. Plans for price hikes over the next three months fell to 24 percent, which is consistent with historic norms. For further context, this measure reached a record 54 percent in November 2021. The trend of fewer businesses planning to raise prices suggests inflation pressures will continue to decline in the coming months.

Concerns related to wage pressures remain elevated at 44 percent, up 4 percentage points from November, but off a high of 50 percent to start the year in 2022. Perhaps of interest to the Fed, hiring plans continued to weaken, with just 17 percent of respondents expecting to add staff in the next three months. For comparison, hiring intentions reached an all-time high of 32 percent in August of 2021. It’s also noteworthy that small business owners are showing less inclination to raise wages, with 27 percent planning to raise employee pay in the next three months, down from a recent 32 percent recorded in October 2022.

The week ahead

Wednesday: The U.S. Census Bureau will release the latest numbers on retail sales before the opening bell. The data should yield insights into whether consumers are tightening their wallets in anticipation of a potential recession.

The Federal Reserve will release data from its Beige Book. The book will provide recent anecdotal insights into the nation’s economy and will highlight emerging regional economic trends.

A week heavy on housing reports kicks off mid-morning with the National Association of Home Builders release of its Housing Market Index. This monthly report has shown significant weakening during 2022, and we will be watching to see if the recent pull-back in mortgage rates has had an impact on the outlook for homebuilders.

Thursday: The flow of housing data will continue when the U.S. Census Bureau releases its December data on housing starts and building permits.

Initial and continuing jobless claims will also be announced. Initial filings have remained low; however, continuing claims have inched higher, signaling that it is becoming harder for displaced workers to find new employment. The labor market is a focal point for the Fed, and we will be watching for signs that initial claims are beginning to point to weakness.

Friday: The week concludes with yet another housing report as updated numbers on existing home sales will be released mid-morning by the National Association of Realtors. This report, along with the new homes data released earlier in the week, should provide a clearer picture of whether the rapid cooling of the real estate market has stabilized.

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