Inflation Heads in Wrong Direction for Fed

Personal Income and Outlays Report Reaction

Thursday’s Q1 GDP report revealed that the US economy is slowing on the back of Fed interest rate hikes, subdued foreign demand, inventory mismatches, and less government spending. Somewhat slower economic output is great news for the Fed, seeking to cut monetary policy rates this year. However, inflation data are headed in the wrong direction, reducing the number and potentially even the likelihood of interest rate cuts this year. Look for an update to our forecasts in early May.

Trusted Insights for What’s Ahead^®

• Consumers ended the first quarter of 2024 with strong nominal and real spending in March. However, real spending continues to outpace real income growth.
• Demand for goods appears to be fading in general. Meanwhile services demand remains robust, but increasing fueled by debt accumulation.
• The savings rate is falling, and interest paid on mounting debt is spiraling higher, suggesting consumers may be nearing the breaking point.
• Headline consumer inflation, as measured by the Personal Consumption Expenditure (PCE) deflator rose month-on-month and year-on-year in March.
• The Core PCE deflator, which excludes volatile food and energy components, stalled out in the month.
• Although economic output showed signs of cooling in the first quarter of 2024, inflation is not cooperating with the Fed’s desire to begin cutting interest rates this year.
• Our call for slower real GDP growth over the second and third quarters still makes sense.
• However, the revised outlook likely will include firmer inflation and few if any interest rate cuts before yearend.

Figure 1. Personal Consumption Expenditure deflators are not cooperating with Fed’s goal to cut interest rates

Note: Core PCE Deflator is total PCE excluding food and energy.

Sources: Bureau of Economic Analysis and The Conference Board.

BEA Report Details

Nominal spending continues to rise. Consumers continued to spend in the final month of Q1. While goods spending was down in the quarter, it rose by 1.3 percent in March on purchases of food, gasoline, and other nondurables. Still services consumption rose by a healthy 0.6 percent on notable increases in spending on a broad set of categories. On balance, the increase in March spending provides positive momentum heading into the second quarter of the year.

Goods drive real spending. The 0.5 percent rise in real PCE in March reflected an increase of 1.1 percent in spending on goods and an increase of 0.2 percent in spending on services. Within goods, the largest contributors to the gain were gasoline and other energy goods (+4.3 percent) (led by motor vehicle fuels, lubricants, and fluids), other nondurable goods (+1.2 percent) (led by recreational items), and food and beverages (+1.1 percent). Within services, the largest contributor to the increase was health care (+0.6 percent) (both outpatient and hospital services).

After-tax Nominal income growth slowing, cutting savings. Nominal personal income rose by 0.5 percent month-on-month in March, largely driven by faster wage growth. Year-over-year nominal income rose by 4.7 percent, unchanged from the previous month. Disposable personal income, which is total income excluding taxes, also rose by 0.5 percent month-on-month. However, after-tax income slowed to 4.1 percent year-on-year from 4.2 percent in February 2024, and an outsized 9.2 percent in February 2023. Consequently, the savings rate dipped to 3.2 percent, the lowest level since October 2022.

Real incomes are growing less than spending, fueling debt accumulation.  Real income rose by just 0.2 percent month-on-month in March and slowed to 1.9 percent year-over-year. Real disposable income slowed to 1.4 percent year-over-year, from a peak of 5.0 percent in mid-2023. On a six-month annualized basis, real spending rose by 3.5 percent in March after slowing to 2.1 percent in January. However, real incomes over the same period real income rose by just 1.7 percent year-over-year. As spending is outpacing income, consumers are financing purchases with debt. Notably, the amount of interest paid by consumers on credit card debt continues to surge. These behaviors are unsustainable and support our view that the economy will continue to slow over Q2 and Q3 and consumers pull back on debt-financed purchases.

Figure 2. Real spending outpacing real income growth

Sources: Bureau of Economic Analysis and The Conference Board.

Figure 3. Debt service rising with credit card use

Sources: Bureau of Economic Analysis, Federal Reserve Board, and The Conference Board.

Services fuel monthly inflation. The total PCE deflator rose by 0.3 percent month-on-month in March, mostly led by services (+0.4 percent). PCE excluding food and energy (core) also rose by 0.3 percent. Among services, housing and utilities costs (+0.5 percent) were up in March on increases in prices for rent, owner’s equivalent rent, and electricity. Transportation services surged by 1.6 percent on increases in nearly every category within motor vehicle services and public transportation (i.e., rail, road, air, water). Financial services prices popped (+0.7 percent) but increases in insurance costs (+0.2 percent) were slightly more subdued after sizable rises in recent months. Other services prices  (+1.0 percent) climbed on higher costs for legal services, personal care and clothing services, and household maintenance.  Goods prices rose by 0.1 percent in the month, mostly reflecting a 1.4 percent increase in gasoline and other energy goods prices.

Services blocking road towards 2-percent inflation target. On a year-on-year basis, the headline PCE deflator ticked up to 2.7 percent, rising back to the November 2023 rate. Core inflation was unchanged at 2.8 percent year-over-year. The favorable progress in the headline inflation gauge is reversing and the core is stagnating. Services inflation is largely driving year-on-year inflation. Housing inflation, which is a huge share of overall inflation and was steadily slowing on a year-over-year basis, stalled over the February-March period. Health care costs are rising as a contribution to year-over-year inflation, as well as financial services and insurance, and other services. Restaurants, recreation services, and transportation services are also continuing to be sizable contributors to annual inflation. Indeed, the stickiness in services prices reflects elevated wages from ongoing labor shortages, rising motor vehicle, life and home insurance, and healthy consumer demand for discretionary services. Meanwhile, goods prices, whose contribution to overall annual inflation had been netting out to zero, is now shifting back to a positive contribution as supply issues raise food and energy prices.

Figure 4. Services inflation stalling after steady slowdown from 2023 peak

Sources: Bureau of Economic Analysis and The Conference Board.

Figure 5. Goods prices starting to add to inflation again

Sources: Bureau of Economic Analysis and The Conference Board.