January's spending shows a hot economy despite rate hikes

REAL ECONOMY BLOG | February 24, 2023

Authored by RSM US LLP

January’s data on inflation and spending came in hotter than expected on Friday, making the case that the Federal Reserve will need to raise interest rates three more times and bring its peak policy rate to 5.5%.

Rising prices and spending indicated that overall demand remained robust, which does not offer the Federal Reserve any relief because it is trying to target demand.

The Fed’s key gauge of inflation—the personal consumption expenditures deflator—rose by 0.6% on the month for both the top-line and the core numbers, bringing the year-over-year inflation to 5.4% and 4.7% for the two series, respectively.

While we have passed the worst of inflation, the sharp rebound in January serves as a reminder that the road to the Fed’s 2% goal will be long and bumpy.

Friday’s data, released by the Commerce Department, also came on the heels of significant upward revisions on past inflation data, which made the inflation outlook even worse.

Before Friday, there had still been hope for a “soft landing” or even a “no landing” scenario when the economy continued to grow despite the steep rate hikes. But with what we are seeing now, the economy is flying too fast and might be heading to a hard landing.

The Federal Reserve has been clear that the risks of doing too little outweigh the risks of doing too much.

Consumer spending

Spending growth was robust in January at 1.8% or 1.1% after accounting for inflation, while income grew by 0.6%. But there are reasons to believe that both series most likely overestimate the underlying strength of the average American consumers.

Much of the increase in income was from a one-time adjustment in Social Security benefits which fueled higher spending, while seasonal factors might also have been at play, masking the real strength of American consumers.

For low- to middle-income Americans who are most sensitive to rising prices, declining excess savings and the erosion of spending power because of inflation have put their spending under pressure.

Their excess savings was drawn down to about $200 billion by the end of 2022, according to our estimates, and their income has not been able to keep up with inflation.

Real disposable income has been stagnant for about two years now. Both help to explain why credit card usage and at the same time debt delinquency have spiked in the past couple of months.