Trending Inflation Is a Cause for Caution

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

Equities continued their strong run last week, with the S&P 500 and NASDAQ hitting record highs. Large technology stocks drove the rally as investors bet that a boom in artificial intelligence will spark supercharged growth for these businesses. However, the persistent path higher in the markets, which has seen the S&P post gains in 16 of the past 18 weeks, points to something more going on. For stocks to steadily climb over the course of several months suggests that investors believe inflation is no longer a threat and that the Fed will be able to cut rates before a recession arrives. This belief comes despite recent rising Consumer Price Index (CPI) readings. Investors may have been overlooking the CPI readings given that the Personal Consumption Expenditures (PCE) index (which is the Federal Reserve’ preferred measure) continued to show inflation fading. That changed last week as the latest PCE data showed traces of what we have been seeing in other inflation measures.

While the market largely shrugged off last week’s release that showed a rise in the latest PCE reading, we believe a closer look at the trends in this report and other inflation measures warrants caution. According to the report, headline inflation rose 0.3 percent in January, up from December’s reading of 0.1 percent. On a year-over-year basis, headline PCE stands at 2.4 percent, down from 2.6 in December. Core PCE, which strips out volatile food and energy prices, rose 0.4 percent in January, up from December’s 0.1 percent gain. On a year-over-year basis, core PCE now stands at 2.8 percent, down from the prior month’s reading of 2.9 percent.

As has been the case for the past several months, the cost of services was the driver of higher prices, with a 0.6 percent rise from December’s reading. On a year-over-year basis, prices for services are up 3.9 percent. As we often note, trends in economic data are more useful than any single reading. Unfortunately, the trend in services inflation suggests that prices are heading in the wrong direction. Consider that on a three- and six-month annualized basis, services inflation is running at a 4.7 percent and 4.1 percent pace. Clearly, this is not the direction the Fed wants to see.

Digging deeper, so-called “super core” services inflation rose 0.6 percent in January, up from December’s reading of 0.3 percent and the fastest pace since February 2022. On a three-month annualized basis, super core services inflation is up 4.1 percent—again, readings are going in the wrong direction.

To be sure, not all of the data in the latest PCE report was discouraging. Goods prices continued to decline, down 0.2 percent in January. On a year-over-year basis, goods prices are down 0.5 percent. The latest drop in goods costs marks the fourth consecutive month of negative readings and the eighth time in the last 11 months that the cost of goods fell. While the decline is welcome news for consumers, we are skeptical that it can continue. As consumer spending patterns normalize, demand for goods will increase. An uptick in demand could lead to firmer prices in the space, and given the low year-over-year comparisons, inflation readings for goods could reverse course.

Given the discrepancy in inflation readings between the two sides of the economy, it makes sense to look at other inflation measures to get a clearer picture. One such measure comes to us from the Dallas Federal Reserve, which calculates the distribution of components weighted by the share of total spending. According to the latest data, more than half (57.67 percent) of the components that are included in calculating PCE showed price increases of 5 percent or more on a one-month annualized basis. Although this represents just one month of data, it’s worth noting that it is very rare to see this portion of components experience this degree of price increases. Setting aside the jump in PCE readings during COVID, the Dallas measure hasn’t recorded a reading like this since 1990 and before that not since the 1980s. While the equity markets have largely ignored the trend of rising inflation, it has caught the eye of the fixed income market. Short-term inflation breakevens (which show what the fixed income market expects the inflation rate to be in the future) have risen sharply in recent weeks. In mid-January, one-year breakevens resided at 1.96 percent. Fast-forward to last Friday, when they were priced at 3.96 percent. During the same period, yields on the two-year breakeven went from 2.09 percent to 2.8 percent. In other words, the fixed income market is expecting inflation to be higher for longer.

Unfortunately, we believe the recent reversal in inflationary trends will continue if the labor market remains tight and wage growth is elevated. Although members of the Federal Reserve have celebrated the progress in bringing price pressures down, they have also acknowledged that a tight labor market and strong economic growth could cause the slowdown in inflation to stall. As such, we continue to expect the Fed to take a higher-for-longer stance on rates, which will ultimately lead to a mild and short-lived recession in the coming months. Fortunately, with inflation expectations still anchored and supply challenges from COVID long gone, the Fed should have room to cut rates to shorten and soften the blow of an economic contraction.

Wall Street wrap

Manufacturing activity dips: The latest data from the Institute for Supply Management (ISM) shows the manufacturing sector extended its streak of contractionary readings to a 16th consecutive month with a reading of 47.8, down 1.3 points from January’s level. Readings for new orders came in at 49.2, down 3.3 points from January. Backlog orders continue to shrink although at a slower pace, with the latest reading at 46.3, up slightly from the prior month’s reading of 44.7. The good news is that while demand remains weak, inventories remain low with customer inventories checking in at 45.8.

It’s worth noting that while orders dipped back into contractionary territory, prices paid continued to expand, with the latest reading coming in at 52.5. Eleven industries in the survey reported paying higher prices compared to 10 in January. This marks the highest portion of industries reporting higher prices since June 2022. This increase suggests that inflation pressures may be at risk reigniting and broadening in the goods sector.

The employment index fell further into contractionary territory at 45.9, down 1.2 points from 47.1 in the prior month. Importantly, in the latest release Tim Fiore, chair of the ISM, noted, “Panelists’ comments in February were equally split between their companies adding and reducing head counts. This approximately one-to-one ratio has been consistent since October 2023.” It’s worth noting that half of the reductions in head count among manufacturers came from layoffs, with the hiring freezes and attrition accounting for the rest.

Consumer optimism takes a step back: Consumer confidence declined in February, ending a streak of three consecutive months of gains. The Conference Board’s consumer confidence index fell to 106.7 in February, down from the prior month’s revised reading of 110.9. The expectations index—which measures consumers’ short-term outlook for income, business and labor market conditions—came in at 79.8, down from January’s reading of 81.5. It’s worth noting that expectations of a recession in the next 12 months moved higher after decreasing in each of the previous three months.

As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In February, those saying it’s hard to get a job rose to 13.5 percent, up from 11 percent the prior month. Meanwhile, those who viewed jobs as plentiful fell to 41.3 percent, down from January’s level of 42.7 percent. The gap between those who find it hard or easy to get a job is the labor differential, something we track closely due to our belief that the current employment picture may make it difficult for the Fed to reach its target of 2 percent inflation. February’s labor differential came in at 27.8, down from January’s revised reading of 31.7. This measure is considered a leading indicator of the labor market. While a single month doesn’t represent a trend, the contraction in the latest reading may suggest that jobs are becoming less plentiful. In a statement released with the data, Conference Board Chief Economist Dana Peterson noted that consumers expressed fewer worries about food and gas prices, but “they are more concerned about the labor market situation and the U.S. political environment.”

Existing home prices move higher: The latest S&P CoreLogic Case-Shiller Index shows home prices for the 20 major U.S. cities rose 0.2 percent in December on a seasonally adjusted basis from the prior month. December’s reading shows home prices are up on a year-over-year basis, rising 6.13 percent year over year. The uptick in home prices comes despite mortgage rates still well above pre-COVID levels. Elevated interest rates and rising prices have made homeownership unaffordable for many. Rising housing prices can also feed into inflation readings, so we will continue to monitor this trend given how it may impact inflation readings in the future.

Continuing jobless claims rise: Weekly initial jobless claims were 215,000, an increase of 13,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 212,250. Continuing claims (those people remaining on unemployment benefits) stand at 1.905 million, an increase of 45,000 from the previous week. The four-week moving average for continuing claims rose to 1.879 million, up 2,750 from last week’s upwardly revised figure and the highest reading since December 2021. The trend in continuing claims is a timely market indicator that suggests the labor market is weakening and those who have lost their jobs are finding it harder to find new employment.

The week ahead

Tuesday: ISM releases its latest Purchasing Managers Services Index. Last week’s report from ISM on manufacturing showed an unexpected slowdown in activity, and we will watch for any signs that the resilient services side of the economy is feeling any pressure. We’ll also be looking at the measure of prices paid. Much as it has in manufacturing, this inflation indicator measure has been trending higher on the services side during the past few months.

Wednesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report. 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.  

The Federal Reserve will release data from its Beige Book. The book provides anecdotal insights into the nation’s economy and has shown economic weakness in many parts of the country as of late. We will be watching to see if this trend continues.

Thursday: Fed Chair Jerome Powell heads to Capitol Hill to present his semiannual monetary policy report. We will be listening to his comments for indications of how he views the labor market, risks of sticky inflation, and the Fed’s expectations for interest rates for the remainder of the year.

The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers have begun to take on more credit card debt in recent months, but overall balance sheets have remained solid

Initial and continuing jobless claims will be out before the market opens. Initial filings fell last week, while 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.

Friday: The BLS will release the Jobs report. We’ll be watching to see if the slowing pace of job and wage gains continued in January. 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 may persist.

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