The Inflation Battle Rages On

Scott Anderson
Chief Economist
Bank of the West

The personal income and spending report for August from the Bureau of Economic Analysis contained some good news on income and consumer spending last month, but also contained some unwelcome inflation data for the Fed. First the good. Nominal personal income climbed 0.3% in August, on par with July and in-line with our forecast. The increase in personal income in August mainly reflected increases in compensation, proprietors' income and social benefits that were partly offset by a decline in personal interest income. Within compensation, wages and salaries rose by 0.3%, down sharply from a 0.8% increase in July and the smallest monthly gain since January. That’s a somewhat encouraging development for the Fed as it attempts to slow wage growth in the still-tight U.S. labor market by hiking interest rates.

Unfortunately high inflation continues to gobble up almost all of those spending and income gains. Real personal income growth was unchanged in August after growing 0.5% in July. From a year ago, real personal income growth was still down 2.3% in August and has been in sharp decline all year.

Real Personal Income Growth Continues To Decline
Real personal spending managed a meager 0.1% increase in August, up from a 0.1% decrease in July. The slight increase was partially supported by consumers’ reliance on savings with the personal saving rate unchanged at a historically-low 3.5% last month.

Real spending on goods fell 0.2% – the second straight monthly decline – with durable goods spending decreasing 0.4% and nondurable goods spending dropping a more modest 0.1%. Real spending on services expanded 0.2%, implying consumers’ are shifting more of their limited discretionary income towards spending on services and away from goods. Real consumer spending growth has slowed sharply since the beginning of the year to just 1.8% year-on-year from 6.7% growth in February.

Consumer Spending Growth Moderated In August
High inflation is the biggest problem for consumers and the Fed right now. While there has been some relief in the headline PCE inflation over the past two months as gasoline and energy prices have eased, growth in the core PCE inflation, which excludes volatile food and energy prices, reaccelerated in August. The core PCE deflator, the Fed’s preferred measure of consumer inflation, increased 0.6% last month after a flat reading in July, pushing the year-on-year growth rate back up to 4.9% from 4.7% in July. This all but ensures the Fed will have little choice but to continue aggressively hiking interest rates for the rest of the year and probably into 2023 even as equity markets and broader financial markets get increasingly queasy.

Annual Growth in the PCE Core Deflator Reaccelerated
Continued high inflation, more aggressive Fed rate hikes and higher overall interest rates, tightening financial conditions, and a stumbling global economy are all expected to weigh more heavily on consumers’ willingness and ability to spend next year. Real personal consumption expenditures growth is expected to moderate further over the next two quarters, before declining 0.8% annualized in the second quarter of next year. The U.S. economy appears most susceptible to a recession sometime in the first half of 2023 with the Fed expected to lift interest rates through February of next year, thereby increasing the risk of tightening into a downturn.

Consumer Spending Growth Expected To Moderate
While stubbornly high at the moment, inflation will eventually respond more noticeably to the Fed’s strong monetary medicine. Core PCE inflation is forecast to continue moderating through 2024 and approach the Fed’s 2.0% target in the second half of 2024. This should give the Fed an opportunity provide at least a few relief interest rate cuts in 2024.

Core Inflation to Gradually Drop as the Economy Slows
The Fed will win its inflation battle in the end, but not without some casualties. Higher unemployment and at least a mild recession are on the near-term horizon for the U.S. economy. And as in any war the ultimate path toward victory remains highly uncertain.

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


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