Labor Market Strength Shifts Focus Back to Inflation

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

In a week light on economic data, the S&P 500 managed to advance despite a re-escalation in the U.S.-Iran conflict. The primary drivers were energy stocks, which rose on the back of an increase in oil prices tied to the conflict, and technology stocks, which saw renewed AI optimism following the U.S. listing of Korean memory chipmaker SK Hynix, which raised $26.5 billion in the largest ever first-time share sale of a foreign company in the U.S. While investors appear to remain optimistic that the renewed conflict in Iran will have a limited impact on the U.S. economy, we continue to believe that the overall stickiness of inflation, as well as the possibility that the Federal Reserve will maintain high rates to combat it, are risks that investors may be underappreciating as we push through the back half of 2026.

Over the past few weeks, data has continued to point to a U.S. labor market that is healing after showing signs of weakness starting in late 2024 and persisting for nearly the entirety of 2025—a condition that spurred the Fed to cut rates even as inflation remained stuck above its 2 percent target. While the June jobs report released on July 2 was weaker than expected, with 57,000 total jobs added and downward revisions to the prior two months of 74,000, the reality is that payroll growth has been strong over the past four months, averaging 137,000 total job additions and 124,500 private job additions. While the other jobs report—the Household Survey, which is used to calculate the unemployment rate—has revealed weakness recently, and the Conference Board’s Consumer Confidence Survey, also released during the holiday-shortened week, hit a five-year high in consumers saying that jobs are hard to get, the preponderance of data suggests the labor market is in a decent place. While there are still pockets of softness, the broader labor backdrop no longer looks weak enough to keep the Fed focused primarily on employment risks.

Last week’s data continued to point to stable labor conditions, with the Institute for Supply Management’s (ISM) Services Sector Purchasing Managers’ Index (PMI) showing the employment component making its biggest leap since 2024 and returning to expansion after spending the prior three months in contraction. (This measure was also in contraction for six of the last seven months in 2025.) This rise comes on the heels of the ISM Manufacturing Sector PMI employment component pushing to 49.7 in June—still in contraction, but the highest since September 2023, when it was at 51.7, its only month in expansion since the end of 2022. In other words, the index has been in contraction in 41 of the past 42 months.

With the labor market healing, investors are left to ponder whether the Federal Reserve will be forced to shift its focus toward returning inflation to its 2 percent target. Investors appear to have become more optimistic about inflation given the pullback in energy prices that occurred after the Memorandum of Understanding (MOU) between the U.S. and Iran was signed in early June. U.S. two-year inflation swaps, a proxy for nearer-term inflation expectations, rose from 2.42 percent on February 27 (before the war began) to a peak of 3.13 percent on May 4 and then began to pull back sharply in June as the conflict cooled and the MOU was announced and signed. This measure sat at 2.28 percent before the recent escalation and ended the week at 2.33 percent.

Against that backdrop, inflation has shifted to front and center and remains one of the biggest questions as we look into the back half of 2026. Markets appear to believe that inflation is tied largely to the recent spike in energy prices from the Middle East conflict and that if those pressures alleviate, inflation will return toward its 2 percent target. However, we believe that risks remain—and that they are not tied solely to the uncertain outcome of the recent escalation in Iran. Indeed, we believe inflation remains sticky even if oil prices remain steady or fall in the future. As we noted in our June 29 commentary, core inflation was accelerating prior to the beginning of the conflict. This acceleration was driven not only by goods prices but by services prices, which remain high. While the ISM Services PMI showed prices paid pulling back to 67.7 in June, that is only a slight decline from May’s 71.3 and remains historically elevated.

We also reiterate our concern that the current AI buildout, while perhaps disinflationary in the longer term and as new Fed Chair Kevin Warsh has opined, is likely a nearer-term source of inflation given the supply chain bottlenecks and price pressures it is causing. The release of the Fed minutes last week from the June meeting showed that these worries were also discussed at the meeting. Notably, officials pointed to concerns that the AI buildout could cause sustained price pressures. At an event on Thursday, New York Fed President John Williams reiterated that his primary inflation concern is demand-driven inflation caused by AI, which could “create a sustained impulse to demand relative to supply in inflation”—something he would not look through but rather respond to by raising rates. Several officials also commented that price pressures had become broad based, with a large share of goods and services experiencing substantial increases.

While many believed the outcome of Fed Chair Kevin Warsh’s first meeting in June was hawkish, we expressed our belief otherwise. We remind readers that while Chair Warsh did not place a dot, he spent the post-meeting news conference talking about the Federal Open Markets Committee’s commitment to “unambiguously and unanimously” return inflation to 2 percent. The irony is that even as the Fed emphasized its commitment to returning inflation to 2 percent, it also raised its own inflation forecast at the meeting to 3.3 percent from 2.7 percent at year-end 2026, with 2027 moving to 2.5 percent from 2.2 percent. Even with its stated commitment, the committee sees higher inflation pressures in the short term, with inflation finally returning to 2 percent in 2028. We believe there is a risk of inflation becoming more entrenched if the Fed chooses to wait to hike rates, should prices stay elevated while the labor market remains steady. While several officials noted this risk, we believe it deserves more attention given that 2028 will mark nearly seven years of the Fed failing to meet its 2 percent target. Despite all of these worries and the hawkish press conference rhetoric, the minutes noted that while a few participants saw a case for raising rates at the meeting, all supported the decision to hold rates steady. We continue to believe that sticky inflation and a Fed forced to do more remain risks in 2026.

While data last week was light, this week is heavy on the economic readings—especially on the inflation front, with consumer and producer prices as well as retail sales, which will provide insight into increasingly price-pressured consumers. While we wait for additional clues on the inflation and labor market fronts, second-quarter earnings season gets underway this week. After a strong first-quarter earnings season that saw 85 percent of companies beat earnings estimates by more than 15 percent, pushing the year-over-year gain to nearly 29 percent, expectations for Q2 remain elevated, with another 23.3 percent year-over-year gain expected according to FactSet. Given how much optimism is already embedded in markets, investors will be focused not only on the reported numbers but also on whether forward guidance confirms optimistic expectations of the last two quarters of the year also posting 20 percent earnings growth.

Wall Street wrap

Services sector keeps expanding

The June 2026 ISM Services PMI showed the largest segment of the U.S. economy remaining in expansion, possibly given a lift by World Cup-related hiring. Overall, the index checked in at 54, down slightly from May’s 54.5 and nearly identical to the six-month average of 54.3. New orders remained in expansion but fell slightly to 55.1 after May’s 57.3, while backlog orders pushed higher to 54.9, the second-highest level since July 2022, indicating that the demand for services is outpacing the capacity of businesses to process and deliver them.

Importantly, employment returned to expansion at 51.2 after three months in contraction. Nine of the 18 services industries, representing over 58 percent of the U.S. GDP, reported higher employment levels in June. Here again, the rise was likely driven by a wave of World Cup-related hiring.

Consumer credit drops after several months of increases

The Federal Reserve’s Consumer Credit Report revealed that total credit outstanding fell by $182 million in May after two straight months of $20 billion increases. This was the first decline in outstanding credit since 2024 and was driven by a $5.3 billion decline in credit card and other revolving credit. Non-revolving credit—student loans and auto loans—rose $5.1 billion.

After splurging in the prior months, consumers appear to have paid down credit cards in May, given that average rate on credit cards rose slightly to 22.15 percent, up from the recent pre-war low of 21.52 percent in February but still lower than the August 2024 peak of 23.37 percent. However, the average rate was as low as 12.74 percent in 2014 and 15.78 percent in May 2020 before surging as the Fed raised rates in 2022.

Home sales remain sluggish

The latest data from the National Association of Realtors shows that the housing market remains challenged, largely thanks to higher mortgage rates and prices that continue to weigh on affordability. June brought in 4.09 million sales, down from an already low 4.19 million in May. The depressed figures are due to a combination of high prices and mortgage rates remaining at 6.6 percent.

The median sales price of homes (non-seasonally adjusted) rose to a record-high $440,000, up from $431,000 in May and up 1.8 percent from June 2025’s $432,700.

The week ahead

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index for June 2026 is scheduled to be released at 6:00 am EST. Optimism among small business owners has soured in recent months, and we will be watching to see if this trend continues. We will be paying close attention to pricing data, after May saw 36 percent of small business owners raising average selling prices, the highest reading since March 2023.

Additionally, the Bureau of Labor Statistics (BLS) will release its June 2026 Consumer Price Index report at 8:30 am EST. We will be watching to see if the general pullback in energy prices drives a slight drop in overall inflation, with core inflation month over month expected to come in at 0.2 percent, keeping the year-over-year rate at 2.9 percent.

Wednesday: The next Federal Reserve Beige Book will be released at 3:00 pm EST, ahead of the next Fed meeting on July 28–29. The document will offer insights into the labor market, inflation, and the overall economy.

Wednesday also sees the release of June’s Producer Price Index from the BLS. We will be watching for evidence of persistent price pressures that suggest inflation remains sticky, which could strengthen the case for the Fed to keep interest rates higher.

Thursday: The U.S. Census Bureau will release the Advance Monthly Retail Sales report for June at 8:30 am EST. We will be watching to see whether May’s solid gain carried into June despite higher borrowing costs and ongoing affordability challenges.

Friday: The University of Michigan will release its Consumer Sentiment Survey at 10:00 am EST. We will pay close attention to consumers’ inflation expectations—especially the five- to 10-year outlook—to see whether Americans are beginning to view higher inflation as a lasting feature of the economy. A decline in long-run expectations, potentially aided by lower oil and gas prices, would be a sign that inflation expectations remain well anchored.

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