Spending remains strong as a key inflation gauge declines toward Fed's target

REAL ECONOMY BLOG | January 26, 2024

Authored by RSM US LLP

Inflation dynamics to close out last year strongly point to a near-term return to the Federal Reserve’s 2% inflation target amid a solid labor market, strong spending and real income gains.

While both top-line and core inflation are rapidly advancing toward the Fed’s target, inflation-adjusted spending increased by 0.5% on the month and by 2.8% on a three-month annualized pace, according to government data released Friday.

Disposable income increased by 0.1% on the month and by 4.2% for the year on an inflation-adjusted paced.

The personal consumption expenditures deflator, closely watched by the Fed, reflected those dynamics, increasing by 0.2% on the month in both the top-line and core metrics while advancing by 2.6% on a year-ago basis and by 2.9% in the core.

In addition, at a three-month annualized pace, top-line inflation advanced at a rate of 0.5% on the month and by 2% at a six-month annualized pace.

The core rate on a three-month pace increased by 1.5% and the six-month pace rose by 2%. Those inflation dynamics in our estimation are creating the conditions for the long-awaited pivot by the Federal Reserve to begin reducing its policy rate.

The policy rate, which now sits at a range between 5.25% and 5.5%, is too restrictive given the disinflation now moving through the economy.

It is now appropriate the Fed at its meeting next week to change the forward guidance inside its statement to a more balanced stance in contrast with its December statement that illustrated a bias toward further rate hikes.

The data

Both income and spending finished the year on a robust note. Personal spending increased by 0.7% on a nominal basis and by 0.5% once adjusted for inflation.

Spending for the year advanced at a 5.9% nominal pace and a 3.2% inflation-adjusted pace. On a three-month annualized pace, real spending advanced by 2.8% in December.

Personal income increased by 0.3% on the month and by 4.7% year over year. Compensation, wages and salaries all advanced by 0.4% on the month, and disposable income increased by 0.3%. On a year-ago basis, compensation rose by 6.5%, wages and salaries increased by 6.8% and disposable income jumped by 6.9%.

The savings rate stood at 3.7%, down from 4.1% in November.

On a year-ago basis, goods inflation remained flat, durables fell by 2.3% and energy prices declined by 2.2% all of which capture the disinflation dynamics that are behind our view of the Federal Reserve’s policy path, with rate cuts starting midyear.

Non-durable goods inflation increased by 1.3% on a year-ago basis while services inflation increased by 3.9% year over year. Food prices went up by 1.5%.

The takeaway

Inflation dynamics inside the metric that the Fed uses to formulate policy strongly imply that the central bank will hit its inflation target in the near term.

This price stability will create the conditions in which the Fed pivots to a multiyear campaign of reducing its policy rate to a range between 2.5% and 3%.

Income and spending dynamics are equally encouraging. Disposable income increased by 4.2% on a year-ago basis, which should put a floor under household consumption once it moves through the traditional holiday hangover. Rising real income and wages should in turn bolster consumer confidence and support solid spending throughout the year.