Spending and inflation cool in May

REAL ECONOMY BLOG | June 30, 2023

Authored by RSM US LLP

Inflation continued to decelerate in May as the Federal Reserve’s key pricing metric—the personal consumption expenditures index—grew by only 3.8% from a year ago, the lowest level in more than two years.

The Fed’s job in restoring price stability, however, is not done. Underlying inflation, as reflected in the more restrictive core and super-core indexes, stayed elevated, according to government data released Friday.

Core inflation—which excludes food and energy—rose by 4.6% from a year ago, while the super-core index—which includes services but excludes housing, food and energy—increased by 4.5%.

Both have greater policy implications than the top-line overall inflation number.

When the slightly lower-than-expected PCE data is considered with the May spending and income data that also came out on Friday, another interest rate hike in July remains likely, while another hike in the remainder of the year is much less likely.

Personal spending rose by 0.1% on the month and stayed unchanged after adjusting for inflation. Income was up by 0.4% as job gains remained robust in May.

While recent remarks from Fed Chairman Jerome Powell indicated the possibility of two more rate hikes as the economy continues to be resilient, we think it is premature to place a bet on another hike anytime after the July meeting.

Despite how strong the labor market and spending have been, both are backward-looking and poor indicators for future recessions.

In the past, spending has started to decline only when the economy is months into a recession, while employment gains can turn down in a few months. That is a clear risk if the Fed continues to be data-driven, and, as a result, backward-looking.

There are also increasing signs within the labor market and manufacturing sector that should add more risks to the soft-landing scenario that Powell has referred to.

Another key data point released on Friday was personal savings. The savings rate in May was 4.6%, while total household savings was $910 billion. That brought the total amount of excess savings in the second quarter in our estimate to about $690 billion.

At the current rate, excess savings should be depleted in the fourth quarter, unable to support further spending growth and align with our timing for the next recession around the back-to-school and early holiday season.

The timing is important to the paths forward for both the economy and the Fed. If our prediction holds true, July would mark the last rate hike in this cycle, while still-elevated inflation and weak economic data from September onward would force the Fed to keep rate at the same level for the rest of the year.

There are more risks to our forecast for the timing than for the outcome that a recession will occur in the next 12 months. That forecast is shared by the Fed in its most recent Summary of Economic Projections.

If the economy stays out of a recession this year, that would mean stickier inflation because of a continuing strong labor market and spending. As a result, that would mean more rate hikes as the Fed tries to cool demand. And a recession would be unavoidable.