Inflation, Recession Fears Slowing Consumer Spending

The May Personal Income & Outlays report is beginning to show the limits of consumer spending amid high inflation and Fed rate hikes. According to the Bureau of Economic Analysis (BEA), US income and spending fell in real terms slowing the pace of consumer spending in 2Q. Real spending is tracking at 1.2 percent over the April-May span, slower than the near 2 percent pace of 1Q. This information places downside risk on our expectation of a rebound in real GDP growth (+2.1 percent Q/Q SAAR) in 2Q after a 1.6 percent drop in the first quarter. Inflation remained extremely elevated as primary drivers are shifting towards food and energy amid the shock to commodity prices amid the war in Ukraine, and housing as rents levitate with home values. Nonetheless, both overall and core inflation gauges are suggesting that year-on-year rates of increase may have peaked in 2Q, but the risk of higher inflation remains.  High inflation rates continue to undermine real incomes this year compared to last year, but consumers appear to continue to spend at least on services, reflecting a combination of a strong labor market, rising wages, and savings. That said, downside risks to consumption remain, largely reflecting the potential for renewed inflation spikes linked to the war in Ukraine and China’s covid-19 lockdowns, the Fed interest rate hikes, and the rising probability of US recession by end-2022.

Headline PCE price inflation came in at 6.3 percent year-over-year (y/y) in May, unchanged from 6.3 percent y/y in April. The BEA also reported that Core PCE Inflation, which excludes food and energy prices, came in at 4.7 percent y/y, vs. 4.9 percent y/y in April. Potentially, the core rate of inflation reached a peak in February, as May marks the third month of slowing in the y/y rate of increase in this gauge. On a month-over-month (m/m) basis, headline PCE price inflation increased by 0.6 percent m/min May, vs. 0.2 percent m/m in April. Meanwhile, core PCE price inflation increased by 0.3 percent m/m, matching the prior month’s gain. Despite rising food (11 percent y/y) and energy (36 percent y/y) prices linked to the war in Ukraine, prices for goods appears to be stabilizing, with slowing used car, furniture, recreational goods, and other durable prices. Meanwhile services prices are picking up with the pandemic in the rearview mirror for many consumers, but also due to rising home prices. Prices for services including restaurants, recreation and travel are increasing as Americans venture out. Surges in prices for new and existing homes are fueling increases in rents, which are a notable share of costs for consumers.

Overall personal income rose by 0.5 percent m/m (in nominal terms) in May, unchanged from the prior month. Employee compensation grew by 0.5 percent m/m (10 percent y/y), proprietors’ income jumped 1.5 percent m/m, and rental income bounced 1.9 percent m/m higher. However, recent increases in personal income have been more than offset by increases in prices. In inflation adjusted terms, personal income fell by 0.1 percent m/m and was down 1.0 percent year-on-year in May. Americans continue to see their purchasing power eroded by inflation

Personal consumption expenditures rose by a modest 0.2 percent m/m (in nominal terms) in May following an downwardly revised 0.6 percent m/m increase in April.  Spending on services rose by 0.7 percent m/m while spending on goods fell by 0.7 percent m/m. Spending on durable goods tumbled by 3.2 percent m/m on broad based declines across categories, while spending on non-durables increased by 0.7 percent m/m as households spend more on food and gasoline. After accounting for inflation, consumer spending fell by 0.4 percent m/m in May as declines in spending on goods overwhelmed increased spending on services.  Real consumer spending over the April-May period is running at +1.2 percent SAAR annualized, after rising 1.8 percent q/q annualized in 1Q.

Today’s report underscores that between elevated and rising interest rates consumers will face continued challenges in the months ahead. As the impact of COVID-19 on the US economy gradually wanes the conflict in Eastern Europe is taking its place as the economic disruptor. Russia and Ukraine are large energy and grain producers and are key global suppliers. With conflict and sanctions curbing this supply, energy and food prices around the world will remain elevated, adding to inflationary pressures and creating further drag on households’ wallets. Importantly, the Fed’s monetary policy tightening program to tame inflation is expected to result in a brief, yet shallow recession in 4Q 2022 and 1Q 2023, as higher rates will reduce domestic demand, and thereby the overall economy (see US Forecast for June).