Why a Slowing Economy Could Help Ease Inflation

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

The major indices capped a solid week of gains with a strong rally on Friday. A downtick in inflation expectations as measured by the University of Michigan Consumer Sentiment Survey sparked the late-week surge. Recall that it was a preliminary reading of inflation expectations from the survey two weeks ago that spurred the Federal Reserve to hike rates 75 basis points at its last meeting. The most recent data put five-year inflation expectations at 3.1 percent, which is closer to long-term averages and shows that higher inflation expectations haven’t yet become embedded in consumers’ minds.

While Federal Reserve Chairman Jerome Powell continued to beat the drum that the Board of Governors is committed to an aggressive fight against inflation, economic data provided new signs that the economy was cooling. Preliminary readings from the S&P Global Purchasing Managers Index show manufacturing input costs rose at the slowest pace since April 2001. Similarly, prices charged on PMI services rose at the lowest rate since March 2021. Equally encouraging was backlog data, which, in aggregate for the manufacturing and services industries, came in at the lowest level since June 2020.

Highlighting slowing economic expansion may seem counterintuitive, but slackening demand is a key component of reducing inflation pressures and could provide room for the Federal Reserve to undershoot rate-hike expectations later in the cycle. Additionally, as we’ve noted in the past, consumers and businesses alike are well-positioned financially to weather a mild economic slowdown if that means that inflation levels return to the Fed’s target of roughly 2 percent.

Slowing economic growth and the Fed telegraphing a willingness to tighten rates as required to rein in rising prices caught the attention of the fixed income markets, where yields on two-year Treasurys dipped to 3.06 percent after peaking intraday at 3.26 percent to start the week. The two-year was yielding as much as 3.432 as recently as June 14. The move is noteworthy because it suggests that investors have softened their views on how far the Fed will have to go in raising rates going forward. If rate expectations continue to stabilize, it will provide clarity in the equity markets and may help define a floor for recent selling pressures.  

Wall Street wrap

Cooldown in demand. The Chicago Federal Reserve’s National Activity report — a measure of 85 monthly economic indicators to gauge U.S. economic activity — came in at .01 for May. Readings above zero signify an economy growing above its historical trend rate, while readings below zero are interpreted as a sign the economy is growing slower than its historic average. The latest reading is the lowest since September 2021 and is another indicator that the Fed’s actions, along with tightening financial conditions, are curbing demand and likely inflation.

Stable employment picture. Initial jobless claims fell by 2,000 for the week ending June 18, while the previous week’s claims were adjusted up by 2,000. The employment market has remained tight and has been a cause for concern that companies struggling to meet staffing needs will be forced to raise wages, which will lead to the type of wage inflation that helped fuel stagflation in the 1970s. However, respondents to the University of Michigan survey show that while current wage growth is elevated and near levels in the 1970s, the median expected change in household income over the next year is just 1.1 percent — far less than the 5-6 percent wage expectations of the stagflation era of the late 1970s and ‘80s.

Not in a buying mood. The University of Michigan survey also found consumers remain sour on buying conditions, with perceptions of conditions for purchases of large household durables, autos and homes each hitting lows not seen since 1978. The pessimistic view suggests further slowing of demand until prices moderate.

Home sales slow. Existing home sales fell to a seasonally adjusted annualized rate of 5.41 million units in May, according to data from the U.S. Census Bureau, versus a pace of 5.6 million in April and well off the 6.49 million rate in January 2022. For further context, the annualized rate of sales of existing homes peaked at a 6.65-million-unit clip in January 2021.

Housing inventories expanded to 1.16 million homes, up from a recent low of just 850,000 units in January. Current levels equate to a 2.4-month supply, up from April’s reading of 2.1 months and well above the January low of 1.5 months.

As higher interest rates continue to impact affordability, we believe housing demand should continue to cool, and housing price growth will flatten or decline in some markets.

The week ahead

Monday: Data on durable goods orders for May will be released to start the day. We’ll be looking to gauge the strength of fixed investments by businesses.

Tuesday: The Conference Board’s Consumer Confidence Report will come out in the morning. Responses related to the ease or difficulty consumers are experiencing in finding new jobs could provide a glimpse of what to expect in next week’s jobs report.

Wednesday: The latest Personal Consumption Expenditures (PCE) price index from the U.S. Commerce Department will be released. The index, which is the Federal Reserve’s preferred measure of rising costs, is expected to show core inflation readings easing to 4.8 percent from last month’s 4.9 percent reading. Likewise, overall inflation is expected to pull back to 6.3 percent from its last reading of 6.4 percent.

Personal income and spending data will also be included in the PCE report. There has been a transition away from spending on goods and toward purchases of services. This report will provide the latest indication of whether the trend has accelerated.

The Bureau of Economic Analysis will release its third estimate of U.S. gross domestic product for the first quarter. The most recent estimate showed the economy contracting by 1.5 percent. A significant revision to the rate could impact expectations for the second quarter.

Friday: Institute of Supply Management will release its Purchasing Manufacturers Index to close out the week. The report offers a valuable real-time look at the current business environment. We will be sifting through the data for the effects of slower growth in manufacturing and paying close attention to insights on the state of supply chains, inventory levels, prices and employment.  

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