Economy Shows Signs of Broadening, but Inflation Pressures Remain a Concern

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

Economic data over the past week showed more progress toward the economy regaining some balance. But there are also signs that the fight against inflation could persist, complicating the Federal Reserve’s task of achieving full employment and price stability. Investors are largely focused on inflation and the potential impact tariffs could have on fueling higher prices in the future. As a result, yield on two-year Treasurys rose, reflecting concerns that tariffs would add inflationary pressures to the economy. Stocks finished lower for the week as investors also worried about the pace of economic growth in the intermediate term. 

Concerns about still smoldering inflation stemmed from data that showed a sharp uptick in wages during the past month, higher input costs for manufacturers and service providers, and a significant spike in consumers’ inflation expectations, which was captured by the University of Michigan’s Consumer Sentiment Survey. Taken together, the reports cast doubt on when the Fed will be able to resume rate cuts after pausing at January’s Federal Open Markets Committee meeting. 

The timing of rate cuts took on additional importance, as last week’s Nonfarm Payroll report from the Bureau of Labor Statistics (BLS) showed job growth fell short of Wall Street expectations. As we detail later in this commentary, the BLS also revised total job numbers for 2024. Those revisions showed that the employment picture was not as robust as previously thought and that the jobs picture in mid- to late summer was likely more fragile than most investors believed. This was the time period when the Federal Reserve cut rates by 50 basis points, noting at the time that it did not want to see further cooling in labor market conditions.  

While investors focused on the risks of inflation over the past week, not all news was bad. Data from the Institute for Supply Management (ISM) showed green shoots of growth in the manufacturing side of the economy with the index tipping into expansion for the first time in months. On the services side, activity slowed but remains solid. The upshot of the reports taken together is that the economy may slow in the coming months, but growth will be more evenly distributed. As regular readers of our commentaries know, we believe a more balanced economy is necessary if the markets are going to continue to post gains. The latest data, while not yet signaling a sustainable trend, fits with our expectation that this year’s market performance will be driven by a larger swath of businesses, albeit at a more muted pace.  

We believe this dynamic will play out as a result of either a resumption of disinflationary trends that allow the Fed to cut rates more than investors currently expect in 2025, a mild slowdown that snuffs out lingering price pressures, or simply the passage of time (during which businesses are able to adjust to higher interest rates). 

A potential wild card in any forecast for the coming months is how the Trump administration acts on tariffs. Since taking office, the president has taken a fluid approach to tariff policy. In some cases, such as with Canada and Mexico, tariffs were implemented and quickly rolled back to allow for a one-month period of additional negotiations. In other cases, such as the 10 percent tariff on goods from China, the administration hasn’t budged since announcing the tax on goods. While it’s too early to draw any conclusions on how tariffs may ultimately be enacted, the President made comments last week suggesting that he may seek reciprocal tariffs against trading partners that levy tariffs on U.S. goods instead of across-the-board duties on all countries.  

Given the uncertainty surrounding the timing and size of future rate cuts, lingering inflation and the potential for tariffs, we believe the markets are likely to experience occasional bumps along the way. While the improvement in broader economic data has allayed some of our concerns, we are still in the late stages of an economic cycle, and risks remain. With that in mind, we continue to build broadly diversified portfolios that represent a balanced, long-term approach to investing. But we have tilted our portfolios toward cheaper asset classes that should benefit when economic participation broadens over the intermediate term. While this approach may mean the portfolios don’t fully participate when market distortions emerge, as they did last year, the benefit of diversification is that it is an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag, regardless of the economic backdrop.

Wall Street wrap 

Mixed jobs numbers: Last week’s Nonfarm payroll report from the BLS showed weaker than expected growth with 143,000 new jobs added in January, including 111,000 positions in private industry. The diffusion index (which measures the portion of the 250 industries covered by the report that added jobs versus those in which employment is unchanged or declining) fell to 55 percent versus December’s level of 57.2 percent. The three-month diffusion index has increased to 64.8 percent, which is well above the more concerning levels seen last summer. When considering the latest data, it’s important to look at how it fits with revisions to previous data. On that front, the total jobs added as measured by the Nonfarm report was revised upward by 100,000 in total for the two-month period ending in December. 

Hourly pay for non-supervisory production employees grew by 0.5 percent for the month and was up 4.1 percent year over year. The pace of wage growth is above the 3 to 3.5 percent rate the Fed believes is consistent with its goal of inflation sustainably at 2 percent. Some of the rise in hourly wages was offset by the number of hours in the average work week. The latest data shows that the average work week fell to 34.1 hours, which is the fewest number of hours recorded since March 2020 and, before that, in 2010, when the economy was coming out of the Great Financial Crisis. The reduction in hours may signal that companies remain optimistic about the future but are trying to save on payroll costs in the near term.   

The BLS also revised the data for all of 2024. As a result, average monthly gains fell to 166,000 from 186,000. Average monthly gains in private industry also declined, coming in at 129,000. A more detailed look at the revisions shows that the job market was even weaker than first feared in mid-summer. The updated totals show that just 66,000 jobs were created in June, 40,000 in July and 33,000 in August. October of last year saw a decline of 1,000 jobs.  

The BLS’s other jobs report, the Household survey, showed the unemployment rate fell to 4 percent from 4.1 percent in December. The labor force participation rate edged higher to 62.6 percent from the prior month’s 62.5 percent.  

Manufacturing gains traction: The latest data from the ISM shows the manufacturing sector expanded for the first time in 27 months. The composite reading for the index for January came in at 50.9, up 1.7 points from the previous month (readings above 50 signal expansion). Strength was solid, with four of the six major industries reporting growth and four of the five subindexes that contribute to overall PMI recording at expansionary levels. Readings for new orders came in at 55.1, up three points from December. This marks the third consecutive month of improved readings for demand. The production index rose by 2.6 points to 52.5, and the employment index tipped into expansion territory at 50.3, up 4.9 points from December. 

Prices moved higher, with the latest reading coming in at 54.9, up 2.4 points from December. This marks the fourth consecutive month that manufacturers have faced higher costs for raw materials. This is the highest level since May 2024. The recent trend in rising costs warrants watching as the Fed continues to try to balance the risks of reigniting price pressures against maintaining a strong job market. 

Growth in services sector slows: ISM data for the services side of the economy showed that the pace of expansion continued to slow, with January’s headline reading coming in at 52.8, down from December’s final reading of 54. While growth overall slowed, strength broadened, with 14 of 18 industries reporting growth, which was five more than last month. New orders declined to 51.3, down from December’s reading of 54.4. Inventory sentiment continues to suggest levels are too high, with the latest reading at 53.5, little changed from the prior month. Prices remain elevated for the services sector but are easing, with the latest reading coming in at 60.4, down from 64.4 in December. The latest reading marks the second consecutive month that the prices index was at 60 or above. Before then, it had not breached the 60 percent level since February 2024. 

The latest results from the survey showed the employment index rose to 52.3, up one point from December’s final reading of 51.3. Six of 18 industries reported growth in employment, while five recorded declines in payrolls; the remaining seven saw little or no change in hiring.  

Consumers’ inflation expectations jump: Consumer sentiment declined in February, down 3.3 points from January’s final reading, according to the latest consumer sentiment survey released by the University of Michigan. The drop was the result of lower optimism about current economic conditions as well as expectations about the future.  

Perhaps most concerning as it pertains to the price stability of the Fed’s dual mandate is the jump in inflation expectations captured by the survey. Inflation expectations for the year ahead jumped one point to 4.3 percent, marking the highest reading since November 2023. This makes the second consecutive month that has seen a sharp uptick in expectations about the pace of price increases. For further context, this is only the fifth time in 14 years in which inflation expectation rose by a full percentage point or more. One-year expectations are now well above the 2.2 percent to 3 percent range during the two years before COVID. 

Expectations for inflation in the coming five to 10 years also rose, coming in at 3.3 percent, up 0.1 percent from January’s final reading. Should the level hold in the final survey results for February, it will mark the highest reading since May and June of 2008, and, before that, August 1996. The Fed focuses on the five- to 10 -year inflation expectations because it can signal that consumers think higher prices will become embedded in the economy, which can lead to changes in consumers’ spending habits. The rise in expectations and the potential impact on buying decisions among consumers is likely to be a concern for the Fed going forward.  

The week ahead 

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index readings for January will be out prior to the opening bell. Last month it showed a rise in expectations about the future but still strained readings for the current business climate. We will watch to see if the brighter outlook continues and if there are signs of improving business conditions taking hold. 

Wednesday: The Consumer Price Index report from the Bureau of Labor Statistics will be the big report for the week. Recent data has shown core inflation readings remain stuck even as headline readings have come down. We will be digging into the data to see if core prices are showing any signs of easing. 

Thursday: The latest readings from the BLS on its Producer Price Index will offer a look at changes in costs for buyers of finished goods for January. We will be watching to see if input costs continue to creep higher, which could put pressure on profit margins or slow the pace of disinflation. 

Friday: The U.S. Census Bureau will release the latest numbers on retail sales for December before the opening bell. Last month’s report showed moderate sales gains, and we will be watching to see if consumers have continued opening their wallets at the store. 

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