Progress in the Fight Against Inflation Slows

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

Equities edged higher last week as bond yields gave ground, and investors cheered generally positive earnings results from a handful of national banks. The gains marked the second consecutive week of positive returns for the S&P 500 as investors continue to try to balance current economic data that has shown unexpected resilience in the face of a 19-month cycle of rate hikes against the risks of the Federal Reserve holding rates higher for longer.

The key to the balancing act continues to be the pace of inflation receding to the Fed’s stated goal of 2 percent. As we detailed last week, while inflation has fallen significantly from its post-COVID highs, the path to further declines may be more challenging unless the job market softens and/or wage pressures subside. Put simply, we believe the Fed will view the current level of wage growth as incompatible with its target for annualized price increases. Data out last week likely reaffirmed those concerns.

The latest Consumer Price Index (CPI) release showed headline inflation grew 0.4 percent in September, down from August’s reading of 0.6 percent but above Wall Street expectations. On a year-over-year basis prices rose 3.7 percent, unchanged from last month. Shelter accounted for more than half of the increase, followed by volatile gasoline prices. The pace of shelter inflation accelerated in September, coming in at 0.6 percent, up from 0.3 percent in August. On a year-over-year basis shelter was up 7.2 percent, a decrease of 0.1 percent from the prior month. As a reminder, shelter has a large and lagging effect on inflation readings in services (it accounts for 35 percent of the total CPI measure and has around a 12-month lag). In recent months we’ve seen price increases for the category ease as year-ago highs roll off the year-over-year calculation.

Core CPI, which excludes volatile food and gas prices, rose 0.3 percent in September, equaling August’s rate. On a year-over-year basis the core reading came in at 4.1 percent, down 0.2 percent from the level of 4.3 percent recorded in August. The latest year-over-year figure marks the slowest 12-month increase since September 2021. The good news is that when you remove the lagging impact of shelter, both all-in CPI excluding shelter and core CPI excluding shelter are up 2 percent year over year. However, additional analysis suggests that wage growth may be an obstacle in further progress to bring inflation sustainably to the Fed’s stated target of 2 percent. The Fed fears that current elevated wage growth may serve to reignite inflationary pressures.

Digging deeper, so-called “super core” inflation, which looks at core services prices excluding shelter and energy, rose 0.6 percent, marking the fastest pace in a year. For further context, the three-month annualized super core inflation rate is 4.8 percent. Chairman Powell has singled out super core readings as one of the measures the Fed watches closely to gauge current price pressures tied to elevated wages. Given the significant uptick in the latest reading, we expect it will serve to reinforce the Fed’s ongoing concerns about wage pressures fueling inflation going forward.

Finally, as we’ve been doing periodically over the past several months, we looked at the Cleveland Federal Reserve’s inflation reading, the 16 Percent Trimmed Mean CPI. This number excludes abnormally high and low categories, and the latest data points to potential stalling in the disinflation process. The latest reading shows prices up 0.4 percent in September, up from August’s reading of 0.29 percent and July’s 0.21 percent. Additionally, median CPI was up 0.45 percent compared to August’s uptick of 0.33 percent and July’s reading of 0.18. The recent move higher in these readings suggest that achieving further progress in reducing price pressures may be difficult until wages begin to soften, which is unlikely to occur without a corresponding recession.

As such, we have not strayed from our baseline expectation that a recession is likely in the coming quarters. However, with current inflation continuing to recede and inflation expectations in line with historic norms, we believe the Fed should be able to pivot quickly to stem a potential economic contraction once the employment picture softens and wage growth is tamed.

Wall Street Wrap

While the CPI reading was the headline for the week, additional reports supplied more signs that the battle against rising prices may persist.

Consumers expect higher inflation in the near term: Consumer sentiment dropped to 63 in October, down 5.1 points from September’s final reading of 68.1, according to the latest consumer sentiment survey released by the University of Michigan. The drop in optimism coincided with an uptick in inflation expectations, with respondents expecting prices to rise 3.8 percent in the coming year. Inflation expectations ended up 0.6 percent from September’s final reading of 3.2 percent. The current reading marks the highest level in five months but was likely driven by a spike in energy prices, which have since eased. We will continue to watch the one-year number but view the latest reading as a temporary blip related to prices at the pump. Long-term inflation expectations, which we believe are more telling, inched higher to 3 percent, up from the prior month’s reading of 2.8 percent but still well within the tight range of 2.8–3.1 percent over the past 27 months.

The latest report shows consumer expectations for their personal economic situations fell by 15 points, with inflation concerns a primary cause of the decline. Likewise, views on general business conditions in the coming year declined by 19 percent.

Input costs edge higher: Producer input final demand prices were up 0.5 percent in September, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The latest monthly reading is down from August’s level of 0.7 percent. On a year-over-year basis, headline PPI is up 2.2 percent. Goods PPI rose 0.9 percent, while prices for service climbed 0.3 percent. Core PPI, which strips out volatile food and energy, was up 0.3 percent for the month following June’s increase of 0.2 percent. Core PPI was up 2.7 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.

Small businesses’ optimism eases as wage and inflation concerns linger: The latest data from the National Federation of Independent Business shows optimism among small business owners fell in September to 90.8, down 0.5 points from August. The reading marks the 21st consecutive month of readings below the 49-year average of 98. Optimism over business conditions in the coming six months fell to a net negative 43 percent, a drop of six points since August.

Inflation continues to be top of mind for respondents, with 23 percent citing it as their primary concern, unchanged from August. The quality of available labor was another top concern, with 23 percent of respondents singling it out as a top challenge and 43 percent of respondents indicating that current openings were hard to fill.

Regarding wage strength, a net 36 percent of those surveyed reported raising wages during the period, unchanged from the prior month. However, 23 percent expect to raise wages in the next three months, a decline of three percentage points from August. While the percentage of small businesses raising pay has eased over the past few months, the pace of the decline has been slow. Concerns about qualified labor and a willingness for business owners to raise pay could signal that wage pressures will prove resilient absent a drop in demand.

As cost concerns have moved higher, businesses have tried to pass along costs to consumers, with 29 percent of respondents saying they raised prices during the survey period, up 2 points from August. Additionally, 30 percent of respondents expect to raise prices during the next three months—this is unchanged from August and marks the second highest level since November 2022. For further context, that figure was as low as 21 percent in April of this year.

Jobless claims hold steady: Weekly jobless claims were 209,000, unchanged from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 206,250, down 3,000 from the previous week’s revised average. Continuing claims (those people remaining on unemployment benefits) were 1.7 million, an increase of 30,000 from the previous week.

The week ahead

Monday: 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.

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.

A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders.

Wednesday: We will get August 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.

The Federal Reserve will release data from its Beige Book. The book will provide recent anecdotal insights into the nation’s economy and will highlight emerging regional economic trends.

Thursday: 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 earlier in the week, should give a clearer picture of whether recent signs of stabilization continue in the face of an uptick in mortgage rates.

The Conference Board’s latest Leading Economic Index survey will be out mid-morning. For months, these reports have suggested the U.S. economy may be on the cusp of a recession. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.

Initial and continuing jobless claims will be announced before the market opens. Initial filings were unchanged last week, and we will continue to monitor this report for signs of changes in the strength of the employment picture.

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