Latest Data Gives Fed Little Reason to Cut Rates

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

Equities ended the holiday-shortened trading week higher, as the major indices wrapped up one of the strongest quarters in recent years. The continued upward march for stocks has been driven in part by a growing confidence that the current strength of the economy means it will be able to avoid slipping into recession and that the Federal Reserve will be able to begin cutting interest rates as early as its meeting in June.

However, we believe that data out last week likely did little to convince the Federal Reserve it should begin to cut rates anytime soon. Final gross domestic product (GDP) estimates for the fourth quarter were revised upward, and the latest reading of the Personal Consumption Expenditures (PCE) Index showed that the disinflationary process is stuck in neutral. We expect the latest data will do little to counter the broadly embraced narrative that the Fed is likely to cut rates three times by year-end, with the first cut coming possibly as soon as June. However, given the latest numbers, we remain skeptical that the Fed will move on rates by the beginning of summer.

The latest PCE reading from the Bureau of Economic Analysis showed that headline inflation rose 0.3 percent in February, down from 0.4 percent in January. On a year-over-year basis, headline PCE stands at 2.5 percent, up from 2.4 in December. Core PCE, which strips out volatile food and energy prices, rose 0.3 percent in February, down from January’s 0.5 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.

In a reversal of recent trends, the rise in goods prices outpaced increased prices for services. The cost of goods rose 0.5 percent in February, the largest increase since January 2023. The February level is up from January’s decline of 0.2 percent and broke a streak of four months of falling prices for goods. Services prices rose by 0.3 percent, down from January’s 0.6 percent pace. On a year-over-year basis, inflation for services remains elevated at 3.8 percent. Goods prices are down 0.2 percent year over year. As we often note, trends in economic data are more useful than a single reading. While the latest data showed the pace of services inflation slowed last month, the trend 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 pace of 4.9 percent and 4.4 percent, respectively. We believe this is likely too hot for the Fed’s comfort.

The continued stubbornness of inflation is also captured in the Dallas Federal Reserve’s Trimmed Mean PCE, which eliminates outliers that can distort traditional PCE readings. According to the latest data, the six-month annualized pace of inflation is 3.1 percent, up from January’s reading of 3 percent and running at the fastest rate since September 2023.

While inflation has receded considerably from its post-COVID highs, the latest readings show more progress needs to be made in bringing it sustainably down to the Fed’s 2 percent target. And in light of recent data that shows the economy continues to grow even as rate hikes take a larger chunk of consumers’ income, we believe the Fed views the possibility of inflation creeping higher as a greater risk than a significant slowdown in the economy. Indeed, the final revisions to fourth-quarter GDP put the annualized pace of growth for the economy at 3.4 percent, up from revised estimates (released in February) of 3.2 percent. The latest data shows the upward revision was driven by strong consumer spending, which accounted for 2.2 percentage points of the 3.4 percent growth in GDP. While strong spending in the fourth quarter could be driven in part by holiday purchases, the latest PCE data shows spending has picked up again. The report shows consumer spending jumped 0.8 percent in February compared to 0.2 percent the prior month. The fact that wage growth remains elevated by historical standards has helped consumers to continue to open their wallets even as interest costs have risen. As a result, we believe the Fed will want to see the pace of wage growth ease further before it initiates rate cuts. Should the Fed hold rates higher for longer as it waits for more clarity on the inflation front, we believe it raises the risk of a mild, brief recession.

Wall Street wrap

A sign of mild growth: The Chicago Federal Reserve’s National Activity report—a measure of 85 monthly economic indicators to measure U.S. economic activity—showed a slight expansion with a reading of .05 for February, up from January’s decline of 0.54. Readings above zero indicate above trend growth, while readings below zero are interpreted as a sign of below trend growth. February’s figure marked the first positive reading since November 2023. Despite the uptick this month, the longer-term trend (with a three-month average reading of -0.18) suggests an economy growing slightly less than its long-term trend.

Consumer expectations dim: The Conference Board’s consumer confidence came in at 104.7 in March, in line with the prior month’s revised reading of 104.8. The expectations index, which measures consumers’ short-term outlooks for income, business and labor market conditions, came in at 73.8, down from February’s reading of 76.3. It’s worth noting that an expectations index reading of less than 80 often precedes a recession.

As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In March, those saying it’s hard to get a job fell to 10.9 percent, down from 12.7 percent the prior month. Meanwhile, those who viewed jobs as plentiful rose to 43.1, compared to February’s level of 42.8. 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 32.2, up from February’s revised reading of 30.2.

While consumers continue to feel optimistic about economic prospects and the employment picture in the current environment, they are more cautious looking forward. The latest expectations index reading is the lowest since October 2023, with the decline driven by deterioration in consumer’s views, future business conditions, the employment picture and income expectations.

Existing home prices rise: The latest S&P CoreLogic Case-Shiller Index shows that home prices nationally rose 0.4 percent in January on a seasonally adjusted basis from the prior month. January’s reading shows home prices are up on a year-over-year basis, rising 6 percent since January 2023, marking the largest year-over-year increase since 2022. Despite the gains in the monthly reading, nationally, sales are being hampered by high interest rates, with 17 regional markets reporting month-over-month declines.

Capital spending rebounds: Preliminary readings for February show business fixed investment moved higher, with non-defense capital goods orders excluding aircraft rising 0.7 percent, breaking a streak of two consecutive months of declines. Shipments declined by 0.4 percent compared to a 0.8 percent increase in January. On a year-over-year basis, readings are up modestly, with capital goods orders excluding defense and aircraft rising 3.0 percent and shipments up 4.2 percent over the past 12 months.

Continuing jobless claims rise: Weekly initial jobless claims were 210,000, down 2,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 211,000, a decrease of 750 from the previous week. Continuing claims (those people remaining on unemployment benefits) stand at 1.819 million, an increase of 24,000 from the previous week’s revised total. The four-week moving average for continuing claims rose to 1.8 million, up 3,500 from last week’s downwardly revised figure.

The week ahead

Monday: The manufacturing sector will be in focus as the Institute of Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index. Recent readings have shown the sector perking up but still hovering around the flat line. We will monitor it for signs of expansion.

Tuesday: 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. We’ll also keep an eye on the so-called “quits” rate to see if workers are feeling confident in their ability to find different or better jobs.

Wednesday: ISM will release its latest Purchasing Managers Services Index. This report along with Monday’s release on the manufacturing side will provide a picture of the strength of the economy as well as insights into inflation trends for businesses.

Thursday: Initial and continuing jobless claims will be out before the market opens. Initial filings were down slightly last week, but 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 uptick in the pace of job gains continued in March. 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 are more likely to persist.

The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumer credit card debt has risen in recent months, but overall balance sheets have remained manageable.

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