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The Weekly Five

Trudging the Last Mile

Feb. 16, 2024


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Katie Nixon, CFA, CPWA®, CIMA®

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

Hopes for a speedy end to the Federal Reserve’s battle with inflation took a blow this week, as several price measures delivered uncomfortable surprises. Economic growth and labor market dynamics still appear adequate to balance strain beginning to appear in some households, and we remain cautious about overreacting to data which may contain misleading seasonal factors. 


Is the Fed’s battle with inflation getting easier with time?

The U.S. Bureau of Labor Statistics’ January Consumer Price Index data presented investors with an unpleasant upside surprise. Core consumer price inflation — which removes food and energy — rose at a 3.9% annual pace, and 0.4% from the month earlier, representing an unfortunate beat over the consensus expectation for more moderate 3.7% annual and 0.3% monthly increases. This is the second consecutive month of a disappointing lack of progress on the disinflation journey — a journey with a hopeful and ultimate destination nearing 2%.

There are several components in the report that were troubling. Shelter costs rose 6.1% against an expectation for continued easing. Assessing Zillow’s rent data, we continue to anticipate inflation in housing costs to fall, but it is simply taking longer than we thought. In addition, price increases in services excluding housing remain stubbornly high, with car maintenance, insurance and airfare costs rising more than expected. Goods prices continue to pressure overall inflation metrics lower, but the stubborn core services — particularly the core services ex-shelter which is Federal Reserve Chair Jerome Powell’s “super core” focus — are improving only in fits and starts. We have long viewed the “last mile” in this inflation fight to be the most difficult leg in the disinflationary journey, and the data confirms that view.


What hints did recent inflation data give us about the future?

In a report that very much rhymed with the CPI release, the Producer Price Index data revealed similar price pressure. The January headline PPI rose 0.3% from December, topping consensus expectations for a much smaller 0.1% increase. Compared with last year, producer prices climbed 0.9%, beating the 0.7% forecast. Core PPI at 2%, meanwhile, was significantly above the 1.8% increase expected by analysts.

Driving the upside surprise were categories like outpatient healthcare and other services-driven costs, which deserves particular attention: Many of these will also be influential in the Fed’s preferred measure of inflation, the core Personal Consumption Expenditures price index, which is now expected to top estimates given the PPI upside surprise.

Energy prices have been a significant tailwind to headline inflation, and ultimately to core disinflation. Looking at the year-over-year comparisons may suggest upward pressure to inflation in the months ahead: For example, the significant decline in crude oil prices in the first half of 2023, potentially leading to less favorable comparisons early this year. In short, the inflation data going forward may be unpredictable.


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Does an inflation surprise derail your expectations for monetary policy?

Rather than overreacting to the recent upside surprises in inflation, we remain focused on the beginning of monetary policy normalization, still on schedule for this year. Market expectations have fluctuated wildly with economic data, from looking for as many as seven cuts starting in March to the current expectation for three to four cuts starting mid-year. We have remained steadfast in our outlook for three to four cuts beginning at the June meeting. For investors, it matters less when the Fed starts the cycle, and more that we will get to the other side of an historically fast and aggressive cycle of rate hikes and monetary policy tightening.

The recent inflation data may look like a setback for some who were anticipating a sooner and larger policy reversal, but we — and the Fed — will not extrapolate the January inflation data into the future. It is always worth remembering that January inflation data can be very noisy, and there are early January salary increases and annual price increases for many services that can influence core inflation data on the producer and consumer fronts. We will continue to be vigilant in assessing the data as it arrives without being unduly influenced. We forecast inflation to continue falling in fits and starts and perhaps even periods of plateauing, but ultimately moving in the right direction consistent with a slowing economy.


Have all of the consequences of rising rates been seen in the economy?

And speaking of a slowing economy: Our soft-landing forecast remains intact as U.S. gross domestic product data have topped forecasts while the U.S. consumer is facing headwinds. January’s retail sales provided a reality check to those anticipating continued momentum in economic growth. We are in an interesting period of consumer push/pull: The overall labor market remains historically tight with demand outstripping supply, job creation strong, and lower-than-forecast weekly jobless claims.

But at the same time we see fraying around the edges of consumer strength despite the strong labor market. Recent data reveal growing strain on household finances. We may finally be seeing the impact of the Fed rate hike cycle on U.S. consumers after a lengthy period when households seemed to be immune to the impacts of higher interest rates. There are already some signs of higher rates putting pressure on household finances: The percentage of U.S. credit card accounts delinquent by 90 days or more has more than doubled since the first quarter of 2022 and is now above both the pre-pandemic level and the 15-year average, according to analysts at Bloomberg Intelligence.

In thinking through the sequence of events that points to pressure on consumers, credit card delinquencies always come first. Credit card payments are the first obligation to see a delay as consumers prioritize mortgage and rental payments, auto and insurance payments, and utilities like cell phone bills. Consumption is two-thirds of our GDP, so this is clearly a trend deserving attention and indicates that strong consumer tailwinds from higher earnings and pandemic savings may be ebbing.


How are markets and companies reacting to evolving economic circumstances?

Financial market reaction to the week’s data dump, while predictable, was most pronounced in the interest rate market. The two- and 10-year Treasury yields experienced a significant re-pricing, with two-year yields rising 20 basis points to 4.68% and the 10-year yield rising nearly 15 basis points on the week, with yields significantly higher on the month — recall the 10-year Treasury yield entered the month at 3.87%, solidly under 4% and reflecting the growing market optimism about the pace and magnitude of rate cuts.

As noted, this optimism has waned in the face of stronger-than-expected growth and inflation. We see this as a familiar pattern of the market overreacting to data that will ultimately prove to be noisy and not disruptive to the overall trend toward lower growth and inflation. It has been interesting to juxtapose the strength in the labor market by nearly all measures with the commentary we are hearing on fourth-quarter corporate earnings calls.

With higher wage costs colliding with a consumer increasingly reluctant to pay more for goods and services, more corporate CEOs and CFOs are focused on operational efficiency to protect — or even improve — operating margins. Operational efficiency can take many forms, of course, but the most obvious trend we are seeing is the substitution of capital for labor. There is a growing chorus of layoffs, most recently with Nike joining the fray and announcing a layoff of about 2% of employees, or approximately 1,700 people. While job cuts remain at low aggregate levels, and we have yet to see the impact of those cuts already announced in the national data, it is clearly a trend.

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