Fed’s Aggressive Interest Rate Hikes Begin Bearing Fruit

Scott Anderson
Chief Economist
Bank of the West

The Federal Reserve’s quest to slow the U.S. economy and lower inflation is gaining some traction. Nominal personal income growth decelerated to 0.2% month-on-month in December, down from 0.3% in November and a robust 0.8% in October. This is the smallest income advance since April 2022. The income increase was driven by a 0.8% surge in rental income, but wages and salaries – which represent just over half of total personal income and are the main supports to consumer spending – rising just 0.3%. In inflation adjusted, real terms, personal income climbed 0.2% in December, unchanged from November but down from 0.4% in October.

Real Personal Income Growth Was Weak In December
From a year ago, however,real personal income improved to -0.4% last month. This is the strongest print in a year, as real personal income growth has been negative for 12 consecutive months amid runaway inflation.

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The impact of higher interest rates is even more pronounced on consumer outlays. Real personal spending declined 0.3% in December following a dip of 0.2% in November. The decrease was driven entirely by a 0.9% drop in goods spending following a 0.9% decline in November. Services spending was flat last month, the first month without an increase since January 2022.

Inflation Adjusted Spending Declined Again Last Month
On a brighter note, high interest rates and tightening financial conditions are having a measurable impact on U.S. inflationary pressures. The personal consumption price index climbed a modest 0.1% in December in line with November’s increase, but down sharply from a 0.4% advance in October. From a year ago, PCE inflation slowed to 5.0% from 7.0% in June.

More importantly for the Fed, the core PCE price index, which excludes volatile food and energy prices, increased 0.3% in December. While this was up slightly from November, it was in-line with the consensus view. Moreover, despite a slight acceleration in monthly core price growth, the increase from a year ago fell to 4.4% from 4.7% in November. Core inflation has moderated for the last three months since posting a 5.2% year-on-year gain in September. This is a visible and sustained slowdown in core consumer inflation, even as further improvement is needed.

Core PCE Inflation Growth Has Fallen For Three Months Consumer Spending Outlook
The slowdown in real consumer spending at the end of last year is likely to persist in 2023 due to rising interest rates and a weakening labor market. We expect the Fed to raise the fed funds target rate by an additional 75 basis points into the spring before stopping to gauge the impact of higher rates on the real economy and inflation. Slowing job growth, volatile equity markets, and declining household wealth are the likely consequences. Real consumer spending growth from a year ago is forecast to continue moderating through the fourth quarter of this year with a weak gain of 0.5%. On an annual basis, real consumer growth is projected to fall to 1.0% from a solid 2.8% for 2022.

Consumer Spending Growth Forecast To Moderate
On an annualized quarterly basis, we expect real consumer spending growth to start to gradually rebound in the second half of 2023 as declining inflation boosts the real incomes of workers who manage to hold on to their jobs. Growth should accelerate further in 2024 as inflation approaches the Fed’s target, allowing the FOMC to begin cutting interest rates from their restrictive stance.

To learn more, check out this week's U.S. Outlook Report.


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