The Fed’s Tough Talk Heightens Recession Fears

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

Encouraging inflation data out last Tuesday was overshadowed by a continued hawkish tone from the Federal Reserve, and the major indices were down sharply for the week. The move lower came despite the latest reading of the Consumer Price Index (CPI), which showed headline and core prices rising less than expected during the past month. Headline inflation rose 0.1 percent in November, down from October’s 0.4 percent increase, while core readings (which strip out volatile gas and food prices) were up 0.2 percent in November, compared to a 0.3 percent increase in October and a 0.7 percent increase in September. On a year-over-year basis, headline CPI came in at 7.1 percent, down from 7.7 percent in the prior reading. Core inflation also improved, with the latest year-over-year reading registering at 6 percent, down from the 6.3 percent level seen in October.

While the markets cheered the unexpected soft inflation readings, the euphoria was short-lived due to Fed Chair Jerome Powell’s hawkish statements made when announcing the Federal Open Markets Committee’s (FOMC) decision to raise rates 50 basis points. Powell reiterated that the board members believe that the battle against inflation continues and that rates will need to move higher for longer than previously expected. The chair’s statements were supported by the latest release of the FOMC’s so-called dot plot of rate expectations, which showed board members in aggregate expect rates to end 2023 at 5.1 percent, up from September’s projection that terminal interest rates would reach 4.6 percent in the new year.

In explaining the Fed’s continued tough stance, Powell acknowledged that recent inflation readings have been encouraging but that concerns remain about rising price pressures as well as a still seemingly strong employment picture. Much as we have been forecasting, goods inflation has crumbled as spending has shifted to the services side of the economy and inventories have been replenished. After being up 12.3 percent year over year, goods inflation has been negative for the past five months and is now up 3.7 percent during the past 12 months. In his press conference, Powell noted the improvement but highlighted still elevated price pressures on the services side. Indeed, services inflation ticked up 0.1 percent in the latest year-over-year reading, coming in at 6.8 percent. However, as we’ve noted in recent commentaries, most of the services component of CPI is shelter, and there is a 12-month lag for rent and housing prices to register in CPI readings. So, although shelter is up 7.1 percent over the past 12 months, it is important to note that rent increases peaked in February of this year, and we have seen declining housing prices for the past three months. Put simply, we expect inflation readings tied to shelter will drop materially in the coming months. Powell acknowledged the lag in data but maintained that the path forward for services prices (excluding shelter) remained uncertain.

While components that comprise services costs may show some variability in the coming months due to the ebb and flow of demand as the economy continues to slow, the overall trend suggests price pressures have peaked. As a reminder, the backward-looking shelter reading accounts for 33 percent of the total CPI calculation. Consider that when housing is taken out of the calculation, services prices were unchanged in November following a 0.1 percent monthly decline for October. Taking a broader view, overall CPI excluding the lagging shelter calculation (i.e., the other 67 percent of the measure) is actually down 0.8 percent since June.

Perhaps tellingly, the bond market appears to have a different take on inflation going forward. The two-year Treasury ended the week yielding 4.18 percent — below the Fed Funds rate range of 4.25–4.50 percent. We note the two-year yield because of its history as being a particularly sensitive indicator of expectations for where the Fed Funds rate is headed. The fact that yields closed lower than the current Fed’s benchmark rate suggests the bond market believes that the FOMC’s hawkish tone is misguided, and the board may have to cut rates in the coming two years. Given the slowing economic data, easing inflation readings and the Federal Reserve’s own recent history of its words not matching its actions, we think the bond market may be on to something. Recall that following the Great Financial Crisis, the Fed was trying (without success) to spur inflation in response to stagnant prices and slow growth. The strategy involved its Treasury-buying program, dubbed quantitative easing (QE). When first unveiled, the Fed announced it would buy a defined amount of Treasurys each month for a set period. The goal was to drive down yields of Treasurys and encourage investors to buy equities or spend more. However, because QE was initially introduced as a temporary program, investors anticipated policy would tighten after its stated expiration, which led to the impact of the move being less than hoped for by policymakers. As a result, the Fed eventually suspended an end date for the program and indicated it would buy Treasurys for as long as it deemed necessary. We believe we could see a similar story play out when it comes to future rate hikes. The current aggressive tone may be the latest effort to prevent financial conditions from prematurely easing by trying to convince investors and consumers that higher rates are here to stay. However, we continue to believe that should the economy and job market deteriorate materially, the Fed will pause rate hikes and could consider rate cuts if warranted by future weak data.

Despite Chair Powell’s focus on services inflation, we continue to believe the Fed is most concerned about the strength of the labor market and underlying wage pressures. As we’ve noted in past commentaries, we believe the labor market isn’t as sound as recent data suggest. There have been significant discrepancies between the Bureau of Labor Statistics (BLS) Nonfarm Payroll and Household reports. The Nonfarm Payroll report is used to measure jobs added in a month, while the Household report is used to calculate the unemployment rate. The two measures occasionally diverge for short periods of time, but over longer periods the gaps between the two generally close. However, the divergence between the two this year has reached historic levels. Since March, the Nonfarm Payroll report shows 2.7 million jobs have been added to the U.S. economy, but the Household Employment report, which has dramatically weakened, shows a net 12,000 employees hired during this same period. We’ve long expected the gap between the reports will shrink, with the two meeting closer to that of the Household number. Indeed, a report out last week from the Federal Reserve Bank of Philadelphia bolstered our position. The bank released its early estimate of the size of revisions it expects to be made to the BLS Nonfarm Payroll reports from March through June of this year. The report estimates that only 10,500 jobs were added during the four-month period as opposed to the 1.04 million initially reported by the BLS. The magnitude of the estimate from the Philadelphia Fed suggests when final annual adjustment are made by the BLS to its Nonfarm data, the number of new hires will be significantly lower than where they stand today.

Of course, talk of an economic slowdown and rising unemployment is not something we take lightly. However, we continue to believe that should a recession arrive in the coming months, it will be mild and uneven given the overall financial strength of U.S. consumers and that it will give way to rising but volatile equity markets in 2023.

Wall Street Wrap

While much of the focus was on the Fed rate hike and the latest CPI reading, other reports out last week continue to show an improving trend in the battle against inflation.

Slowing cost pressures and improving inventories: Preliminary readings from the S&P Global Purchasing Managers Index show growth input costs for services slowed dramatically, rising at the slowest rate since December 2020. Likewise, prices charged on PMI services rose at the slowest rate in more than two years. The easing prices were partially in response to lackluster demand, which drove overall activity in the services sector to 44.4 percent, down from 46.2 percent in November (readings below 50 signal contraction).

On the goods side, weakness continued to spread, with preliminary readings for goods manufacturing coming in at 46.2, down from November’s reading of 47.7. The drop in activity was the largest decrease since the initial period of COVID lockdowns in early 2020. New orders for manufactured goods also fell at the fastest clip since the Great Financial Crisis of 2008–09. On a brighter note, input costs fell, and supplier delivery times continued to improve. The upshot of weak demand and easing costs is that pricing power for manufacturers and services has been significantly curbed.

Independent businesses feeling inflation relief: The latest data from the National Federation of Independent Business show that inflation pressures are easing, with the percentage of owners raising selling prices falling from 71 percent early in the year to just 56 percent in November. Similarly, during the same period, the percentage of businesses cutting prices has doubled, from 4 percent to 8 percent. The percentage reporting higher labor compensation fell to 39 percent from 50 percent. Additionally, plans to hire were down, with just 18 percent of respondents reporting they anticipate adding to staff, compared to 28 percent at the beginning of the year. This reading was at 32 percent as recently as August. Historically, declines of this magnitude have preceded periods of rising unemployment.

Optimism among independent business owners crept higher in the latest survey but marked the eleventh consecutive month of readings below the survey’s 40-year average.

The weeks ahead

There will be no commentary the next two weeks as we enjoy the holidays (and hope you will as well). We’ll be back in the new year to dig into markets week by week. Of course, we will still be monitoring the economic data over the next two weeks, including several reports on the state of the housing market out next week as well as the latest Personal Consumption Expenditures Price Index (PCE).

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