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Economic Update | Past Peak Inflation?

By Dr. Uric Dufrene, Sanders Chair in Business and Professor of Finance, Indiana University Southeast

A few weeks ago, we wrote about the tug of war between prices, growth, and profits. We saw some of this play out in the past couple of weeks with the market significance and impact of inflation, through the announcement of the Consumer Price Index (CPI). The consensus was 8.7% on the annual CPI rate, and the release came in at 8.5%. It is a given that 8.5% is significantly above the preferred 2% range of the Fed. However, this was the first time in a while (don’t quote me, but I think all of 2022 and part of 2021) that the actual was less than expected. The month-over-month change was flat or 0%. The core, which removes the cost of food and energy, was also less than expected at 5.9%. The CPI release was met with a strong bounce in the equity markets.

Declining fuel prices and overall moderating prices will have a positive impact on consumer sentiment. We saw this with the latest release of the Michigan Consumer Sentiment survey. This measure of consumer sentiment had seen historic low levels and was dragged down by consumer frustration with inflationary prices. If we go back a few decades, we observe a negative correlation between consumer sentiment and inflation. In a nutshell, when prices are up, sentiment is down. When prices are down, sentiment is up. The last report saw an uptick in consumer sentiment, with the index hitting 55.1, higher than the consensus estimate of 52.5. If we continue to see moderating prices, especially at the pump, look for consumer sentiment to continue to rise. Sentiment will also get a boost from recovering equity prices, excluding the bumpy ride observed last Friday and Monday of this week.

With respect to the consumer, resilience is the word. Retail sales, ex-autos, and fuel came in much higher than expected. These are not adjusted for inflation, but you are not seeing a collapse on the part of the consumer. Overall retail sales were flat from month over month. After stripping out automobiles and fuel, retail sales increased by .72%, and this was more than double the expected amount of .32%.

Manufacturing saw mixed data over the past couple of weeks. The Empire State Manufacturing Index, a measure of manufacturing in the New York area, plummeted from the month prior. The consensus was 5.5 and the actual was -31.3, compared to 11.1 in the prior month. This is only one indicator, and it takes more than one data point to establish a trend. This is one to watch.

While the New York report was dismal, the Philly Fed showed the complete opposite. Manufacturing rebounded from the previous month, with the index showing 6.2, compared to an estimate of -5.0, and a prior reading of -12.3. These regional indicators tend to be volatile from month to month, but we can glean information about the overall trajectory of manufacturing. Industrial production was more consistent with the Philly manufacturing indicator. The Industrial Production Index came in at .6%, beating an expectation of .3%. The manufacturing component of the index was also quite strong, coming in at more than double the consensus estimate.

While some of these indicators are mixed, I’m still in the camp of an overall positive outlook on manufacturing. The inventory-to-sales ratio moved up a bit, given the increase in inventory levels. However, the ratio is still depressed compared to pre-pandemic levels, and significantly under the average over the past 30 years.

The labor market continues to show signs of strength. We saw the blowout jobs report last month with over 500,000 jobs added. The past two weeks saw no significant run-up in unemployment claims. The last week, in fact, saw a decline in weekly claims. New claims for unemployment were at 250,000, well below a number we typically associate with a recession.

Locally, the unemployment rate in Indiana increased by .2% points in July. This was the highest rate increase in the country. The state’s labor force increased by around 15,000 and the number of unemployed increased by about 8,000. So, while we did see an increase in the number of unemployed, the positive aspect of the report was that this was due to labor force growth, which is what we need to see.

What does all this mean? The market was jubilant because inflation may have peaked. If we are indeed past peak inflation, the Fed may have the ammunition it needs to reduce the aggressiveness of rate increases. So, instead of 75 basis points, 50 basis points may now be possible. This Friday will be a big day with an address by Chairman Powell. Lower interest rates are good for valuations, and that’s why we saw the strong equity bounces in the market. If equity valuations hold, combine this with moderating prices, and you will see consumer sentiment start to rebound. All this does not mean that we will escape slower growth, that is coming. With only a few upticks in the unemployment rate, along with more positive consumer sentiment, the Fed may get the soft landing it has been seeking all along. As we close out the year, look for profits to take center stage.

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