Wages Are the Fed’s Final Obstacle

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

Equities were down for a second week despite a growing belief among investors that the Federal Reserve has successfully broken the back of inflation without sparking a recession. The optimistic read is rooted in the ongoing unwinding of price pressures and a belief that the Fed’s rate hike cycle is at or very near the end, even as the economy continues to show signs of strength.

To be sure, inflation data out last week painted a mostly positive picture on progress in the disinflationary process. And while we believe the chances of a soft landing have improved, we remain skeptical the Fed will be able to declare victory over the post-COVID spike in price pressures without seeing a material weakening of wage growth. As we’ve noted in the past, history suggests that the Fed views annual wage growth of 4 percent as a threshold for what the economy can absorb without sparking elevated price pressures. The Fed is afraid of a repeat of the period of embedded high inflation that occurred from 1966–1982, a period characterized as being driven by a wage-price spiral in which rising wages were used to pay ever-rising prices. A return to the dynamic of the 1970s and early ’80s is the paramount concern and why the Fed is intently focused on the tight labor market, which is the final battle front in the fight to keep price pressures tamed.

While a sustained uptick in productivity or a sharp increase in the number of available workers could alleviate wage pressures, we have seen little evidence to suggest either is likely to occur. And with anecdotal evidence of workers, such as drivers and warehouse staff at United Parcel Service, recently winning significant wage increases, we believe there is risk that companies will begin to feel pressure to raise wages as competition to land workers may heat up further. As a result, we believe employment costs may prove resilient absent an economic downturn.

Until annualized wage increases consistently register in the low to middle 3 percent range, we believe the Fed will likely continue to use its tools to drain liquidity from the economy in hopes that growth slows and wage pressures ease. Fortunately, with inflation falling as it has, and with inflationary and wage expectations well anchored, the Fed should have room to reverse course as necessary should an economic downturn take hold.

Wall Street Wrap

Consumer price pressures returning to historic norms: The latest Consumer Price Index (CPI) release showed price pressure continuing to fade, with headline inflation growing 0.2 percent in July, unchanged from June’s reading and below Wall Street expectations. On a year-over-year basis, prices rose 3.2 percent, up slightly from the prior reading of 3 percent. However, the increase was expected due to an unusually low monthly reading for June 2022 rolling off the twelve-month total. Once again, shelter was a driving force of the rate of increase for the monthly reading coming in at 0.4 percent and accounting for 90 percent of the month-over-month increase in the headline number. On a year-over-year basis the category was up 7.7 percent in July, a decrease of 0.1 percent from the prior reading. As a reminder, shelter has a large and lagging effect on inflation readings in services (it accounts for 34 percent of the total CPI measure and has around a 12-month lag).

When the backward-looking shelter category is removed, current measures show prices are up 1.0 percent year over year—well below the Fed’s stated target of 2 percent.

It’s important to note that home prices peaked in the U.S. in June 2022, and given the lag of housing feeding into CPI, we expect the shelter component will continue to moderate in the coming months and will result in further easing of the inflation measure. Core CPI, which excludes volatile food and gas prices, rose 0.2 percent in July, unchanged from June and tied for the smallest increase since August 2021. On a year-over-year basis, the core reading came in at 4.7 percent, down 0.1 percent from the level of 4.8 percent recorded in June. The latest year-over-year figure marks the slowest 12-month increase since October 2021. Once again, if shelter is taken out of the equation, core CPI comes in at 2.5 percent year over year, the lowest level since March 2021.

Dissecting the data further reveals that food and shelter combined have been significant drivers of high year-over-year readings. When those two categories are removed, all-in inflation is actually flat.

Further evidence that inflation pressures have largely retreated save for a few pockets can be found in the Cleveland Federal Reserve’s inflation reading called the 16 Percent Trimmed Mean CPI, which excludes abnormally high and low categories. The latest reading puts inflation at 2.56 percent year over year, in line with “normal” historic levels.

Input costs edge higher: Producer input final demand prices were up 0.3 percent in July, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The latest monthly reading is up from June’s downwardly revised level of 0 percent. On a year-over-year basis, headline PPI is up a meager 0.8 percent. Consistent with consumer inflation readings, services was a driver of higher prices, with PPI for the category up 0.5 percent, while goods PPI rose just 0.1 percent. Core PPI, which strips out volatile food and energy, was up 0.2 percent for the month following June’s decline of 0.2 percent. Core PPI was up 2.4 percent on a year-over-year basis. The PPI measures price increases for finished goods leaving the factory; it is generally a forward-looking measure of where prices for consumers are headed. As the costs producers face for finished goods remain controlled, we expect to see further price relief for consumers at the retail level.

Consumer sentiment stable: Consumer sentiment came in at 71.2 in August, compared to July’s reading, which jumped to 71.6, according to the latest consumer sentiment survey released by the University of Michigan. The latest reading is now about 42 points higher than the all-time low for the measure recorded in June 2022. While the increase is significant, the reading is still well below the long-term average of 86.

The survey also showed that inflation expectations remained anchored, with respondents expecting prices to rise 3.3 percent in the coming year, a decrease of 0.1 percent from July’s reading. Long-term inflation expectations declined modestly to 2.9 percent from the prior month’s reading of 3.1 percent. The latest long-term expectations reading marks the 24th time in the past 25 months that expectations fell within a range of 2.9 to 3.1. The range of expectations over the past two years is consistent with readings for this measure recorded during “normal” periods of inflation during the past 30 years. For further context, both one-year and long-term (five to 10 years) inflation expectations peaked in 1980 at 10.4 percent and 9.7 percent, respectively. The difference between current readings and those from 1980 highlight how inflation continues to be viewed as a temporary problem, which should make it easier for the Fed to cut rates as necessary to spur economic growth.  

Finally, respondents expect their median household income will rise 2.2 percent during the next one to two years. This is well below the 6.5 percent figure recorded in June 1980, during the thick of the wage–inflation spiral of 1966–1982.

Small businesses' optimism grows, but wage concerns linger: The latest data from the National Federation of Independent Business (NFIB) shows optimism among small business owners inched higher to 91.9, up 0.9 points from June. However, the reading marks the 19th consecutive month of readings below the 49-year average of 98.

The optimism reflects further easing of inflation concerns, as just 21 percent of respondents cited cost pressures as a primary worry, down from July 2022’s reading of 37. As cost concerns have receded, so have price hikes for consumers, with 25 percent of respondents saying they raised prices during the survey period. While the figure is still high by historic standards, it is important to note that as recently as March 2022, 66 percent of those surveyed had raised prices. The latest reading highlights the speed at which the move toward higher prices has dissipated.

As it relates to wage strength, a net 38 percent of those surveyed reported raising wages during the period, up 2 percent from June’s reading, and 21 percent expect to raise wages in the next three months, down 1 percent from June. While the percentage of small businesses raising pay has eased over the past few months, the pace of the decline has been slow. With price increases receding faster than wages, profit margins and earnings for companies may come under pressure in the future. If this trend continues, we would not be surprised to see an uptick in layoffs.

Jobless claims move higher: Weekly jobless claims rose to 248,000 from last week’s 227,000 new claims. The four-week rolling average of new jobless came in at 231,000, up 2,750 from the previous week. Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.684 million, down 8,000 from the prior week’s revised reading.

The week ahead

Tuesday: 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 adjusting their spending habits as a reflection of their expectations for the economy going forward.

The Empire State Manufacturing Index released before the opening bell will offer a look at the health of manufacturing and general business conditions in the influential New York state region.

Wednesday: We will get July 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 whether consumers can expect greater housing inventory in the months ahead.

Wednesday offers a look at the minutes from the most recent meeting of the Federal Reserve board. We’ll be looking for comments related to forecasts on economic growth for the remainder of the year as well as any signs of differing opinions on the need for further rate hikes for the year.

Thursday: The Conference Board’s latest Leading Economic Index survey for July will be released shortly after the market opens. For the past several months, the report has suggested the economy is on the cusp of or in a recession. We will be scrutinizing the data for any indications of a change in the pace of softening.

Initial and continuing jobless claims will be announced before the market opens. Initial filings were up last week, and we will be watching to see if there are additional signs of softening in the labor market.

Follow Brent Schutte on Twitter and LinkedIn.

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