Why the Pace of Disinflation Is So Important

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

If you watched only the Dow Jones Industrial Average over the past week, you might think the markets and economy are humming along nicely. The index rose to new highs, closing on Friday above 40,000 for the first time ever. Investors still exude bullish optimism, believing that the Fed will be able to bring inflation under control without causing a recession—the so-called soft landing.

We wish we shared that kind of optimism—however, the data we watch closely still gives us pause. News on the inflation front over the past week had a little something for any viewpoint. Those in camp bull focused on the Consumer Price Index (CPI) coming in below Wall Street expectations. But a further dive into CPI and a look at other inflation data suggest progress toward the Fed’s 2 percent target remains painfully slow.

The pace of the disinflationary process may take on greater significance going forward, as other economic data out last week raised questions as to the resiliency of the consumer and the economy as a whole. The longer the Fed needs to wait to be sure the inflation genie is fully back in the bottle, the more likely the cracks in today’s data will widen to a mild recession.

At this point we’re in a race to see which cracks first—inflation or the economy. And even if inflation cracks first, will the Fed be able to cut rates quickly enough to prevent the economy from cracking as well?

You can find an example of economic cracks in data released by the Federal Reserve Bank of New York. It shows consumers took on more debt during the first quarter of the year and that they were falling further behind on their loan payments. According to the report, household debt levels grew by 1.1 percent during the quarter to $17.69 trillion. At the same time, 3.2 percent of all loans were in delinquency, with credit card debt (8.9 percent) and car loans (7.9 percent) showing the highest rates of delinquency. And when you dig deeper, credit card and auto loans that are seriously delinquent (more than 90 days) are now above levels they were at just prior to the 2007 and 2001 recessions.

The rise in debt balances and delinquencies comes at a time when consumers have exhausted the excess savings they accumulated during COVID. According to a recent analysis by the Federal Reserve Bank of San Francisco, consumers now have $72 billion less in savings than they did at the beginning of the global pandemic. As recently as August 2021, consumers had amassed $2.1 trillion in excess savings. This translates to roughly $70 billion in savings being spent every month since the peak. It’s worth noting that the pace of the savings drawdown is estimated to have increased to $85 billion each month since last fall.

With savings depleted, debt balances rising, and borrowers falling behind on their payments, it may be just a matter of time before consumers pull back on spending. Should that occur before the Fed can cut interest rates, a slowing economy could transition into contraction. Fortunately, that would likely spell the end of any lingering inflation pressures, and the Fed should be able to cut rates to restimulate economic growth.

Wall Street wrap

Data out last week offered some potential warning signs about the economy and the challenges that are putting a strain on businesses.

Small business owner optimism inches higher: The latest data from the National Federation of Independent Businesses (NFIB) shows optimism among small businesses rose by 1.2 points to 89.7, marking the first increase this year. However, the latest measure marks the 28th consecutive month of readings below the 50-year average of 98.

While survey respondents were modestly more upbeat than they were in March, when the optimism survey registered its lowest reading in more than a decade, inflation remained a top concern. NFIB Chief Economist Bill Dunkelberg noted in a statement released with the latest survey results, “Cost pressures remain the top issue for small business owners, including historically high levels of owners raising compensation to keep and attract employees.”

The latest results show 22 percent of respondents listed inflation as the single largest challenge facing their business, down 3 points from March. In response to cost pressures, a net 25 percent of business owners reported raising prices, off three points from March. Conversely, there was encouraging news on the inflation front going forward with the number of respondents planning to raise prices in the coming three months dropping to a net 26 percent, down seven points from March. While the portion of business owners planning to raise prices has moderated slightly in the past few months, it remains well above historic norms. As we have highlighted in previous commentaries, there has been a correlation between small business plans to raise prices and inflation.

When it comes to sales, actual sales fell from negative 10 to negative 13. Going forward, despite some improvement in sentiment, business owners are still decidedly concerned. A net negative 12 percent of all owners expect higher inflation-adjusted sales in the next three months. Perhaps in a sign that tighter financial conditions are seeping deeper into the economy, a net 8 percent of respondents noted their last business loan was harder to get, and 21 percent reported paying a higher interest rate (compared to 17 percent in March). The outlook for general business conditions fell to negative 37—one of the lowest readings ever.

Meanwhile, concerns about labor costs persist for business owners. The latest data shows that 11 percent of respondents named labor quality as their top concern, up 1 point from March. Relative to the job market as a potential source of inflationary pressures, 38 percent of small businesses reported raising compensation, unchanged from March. With the exception of January’s reading of 39 percent, this is the largest portion of businesses to raise wages since July 2023. A net 21 percent of business owners expect to raise wages in the next three months, also unchanged from the prior month.

Against a backdrop of poor sales (revenues) but elevated labor costs (expenses) and declining ability to raise prices given the Fed’s rate hike campaign, companies have cut back on hiring. Plans for adding staff moved higher, with a net 12 percent expecting to add workers, up 1 point from March. Despite the increase, this number is still historically low. Besides a few months during COVID, you’d have to go back to 2016 to find a time when such a small number of businesses planned to add workers. The question looking forward is whether these companies will eventually have to cut jobs to cut expenses and protect margins.

Jobless claims dip: Weekly initial jobless claims were 222,000, down 10,000 from last week, which was the highest level since August 2023. The four-week rolling average of new jobless claims came in at 217,750, up 2,500 from the previous week’s average.

Despite the dip in weekly claims, there are still signs of cracks in the labor market. Continuing claims (those people remaining on unemployment benefits) stand at 1.785 million, up 17,000 from the previous week’s revised total. The four-week moving average for continuing claims came in at 1.77 million, down slightly from last week.

While the national unemployment rate is still at 3.9 percent, 21 states are now triggering the so-called Sahm rule. That’s up from 18 in March. According to this rule, developed by former Federal Reserve economist Claudia Sahm, since 1960, every time the three-month moving average of the national unemployment rate rose by 0.5 percent or more from the previous twelve month low, a recession has followed. While the national Sahm rule is at .37, we have never had 21 states violate the rule in the past without a recession following.

Inflation remains elevated: The latest CPI reading from the Bureau of Labor Statistics showed that headline inflation increased 0.3 percent in April, less than Wall Street estimates. The latest reading is down from March’s 0.4 percent increase. On a year-over-year basis, the headline figure was up 3.4 percent, a decrease of 0.1 points from March. Core inflation, which excludes volatile food and energy costs, rose 0.3 percent in April, down from March’s pace of 0.4 percent, and is now up 3.6 percent on a year-over-year basis. Prices for gasoline and shelter accounted for most of the headline reading increase.

Goods prices declined 0.1 percent for the month and are now down 13 percent on a year-over-year basis. In contrast, the pace of services inflation remained elevated, up 0.4 percent in April and rising by 5.3 percent year over year. While shelter continues to be cited as a sticking point in recent services readings, even when the category is removed, services prices are up 4.92 percent from year-ago levels. This is moving in the wrong direction; back in September services prices without housing were up 2.8 percent year over year.

Digging deeper, so-called “super core” services excluding shelter inflation (often mentioned by Chair Powell) rose 0.42 percent in April, down from March’s reading of 0.65 percent but still up 4.9 percent over the past 12 months. On a three-month annualized basis, super core services inflation is up 6.34 percent and 6.5 percent on six-month annualized basis—again, readings are going in the wrong direction.

Other inflation measures point to a stalemate on the inflation front. Indeed, the annualized reading of the Cleveland Federal Reserve’s inflation reading, called the Cleveland Median CPI, came in at 0.35 percent in April, translating to a 12-month annualized pace of 4.3 percent and in line with March’s reading. For context, this measure is still well above the one-month annualized pace of 2.5 percent from July 2023.

Finally, the Atlanta Federal Reserve’s Core Sticky Consumer Price Index rose at an annualized pace of 4.6 percent in April. Over the past three months, this measure shows core sticky inflation rising at an annualized rate of 4.7 percent compared to a year-over-year rate of 4.4 percent. Simply put, the trend suggests inflation readings have plateaued well above the Fed’s target of 2 percent.

Costs for producers jump: Producer input final demand prices rose 0.5 percent in April, up from March’s decline of 0.1 percent, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. On a year-over-year basis, headline PPI is up 2.2 percent, the highest year-over-year pace since April 2023. Core PPI, which strips out volatile food and energy and trade, was up 0.4 percent for the month, up from March’s 0.2 percent increase. Core PPI was up 3.1 percent on a year-over-year basis, also the largest year-over-year increase since April 2023. The PPI measures price increases for finished goods leaving the factory.

Forward-looking indicators fall again: The Leading Economic Index (LEI) from the Conference Board fell 0.6 percent in April, the second straight month of decline. Over the past six months at an annualized pace, LEI has fallen 3.8 percent. The Conference Board notes that for a second straight month the index is no longer signaling a recession. However, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted that the index's growth rates “still point to serious headwinds to growth ahead. Indeed, elevated inflation, high interest rates, rising household debt, and depleted pandemic savings are all expected to continue weighing on the U.S. economy in 2024.”

Retail sales stall: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in April were flat in April, compared to a 0.6 percent rise in March. The latest report shows retail sales are up 3 percent on a year-over-year basis. Seven of 13 categories measured saw decreases, led by non-store retailers. The latest decline in spending comes on the heels of March’s unexpectedly strong retail sales report. Consumer spending has been a driving force in the post-COVID recovery, and we will be watching to see if the recent weakness is an anomaly or if depleted savings and rising credit card balances are starting to weigh on consumers' spending habits.

The week ahead

Wednesday: The day offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for board members’ thoughts on the employment picture and wages and looking to see if there was any divergence in opinion as to the possible timing of future rate cuts.

We’ll get a look at existing home sales mid-morning from the National Association of Realtors. This report, along with the new homes data released later in the week, should give a clearer picture of whether recent signs of improvement continue in the face of recent increases in mortgage rates.

Thursday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for May. Activity slowed last month in both sectors, and manufacturers faced higher prices. We will be watching for signs to determine whether the downtick in orders seen in last month’s survey results was a temporary statistical blip or the beginning of a trend. Prices paid will also be a point of interest for us.

The Chicago Federal Reserve Bank releases its national activity index. The report looks at economic activity across the country and related inflationary pressures. Last month showed a second consecutive month of modest growth. We’ll be watching for indications of whether the uptick has staying power and shows any signs of gaining momentum.  

Initial and continuing jobless claims will be out before the market opens. Initial and continuing claims dipped last week. We’ll continue to monitor this report for signs of changes in the strength of the employment picture.

The U.S. Census Bureau will release data on new home sales for April. We’ll be looking at this data to assess the impact the recent uptick in inflation and fluctuations in mortgage rates have had on demand for newly built homes.

Friday: Data on durable goods orders for April will be released to start the day. We’ll be watching for signs of the direction of business spending in light of solid economic growth but rising inflation pressures.

We’ll also get the final numbers from the University of Michigan Consumer Sentiment Survey for May. Initial readings showed a large drop in sentiment as inflation expectations moved higher and concerns about the job market grew. Longer-term inflation expectations will be of particular interest. The preliminary reading showed expectations for inflation five to 10 years out had risen to the top of a narrow range it has been in during the past few years. If it moves above that range, it may raise additional concerns for the Fed as it debates when to begin cutting rates. That’s because the Fed has consistently stressed that one of the factors it watches closely is the inflation expectations of consumers.is consumers’ inflation expectations.

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