Spending holds strong as inflation moderates in October

REAL ECONOMY BLOG | December 01, 2022

Authored by RSM US LLP

Overall demand remained robust as holiday shopping kicked off in October, according to data on inflation, spending and income from the Bureau of Economic Analysis released on Thursday.

Spending rose by 0.8% while income increased by 0.7%. After adjusting for inflation, real spending rose by 0.5% and income was up by 0.4%.

The Federal Reserve’s preferred inflation metric—the personal consumption expenditures price index—came in better than expected. While overall PCE inflation was unchanged at 0.3% on the month, core inflation slowed significantly to 0.2% from 0.5%. On a year-ago basis, inflation moderated to 6.0% while core inflation was down to 5.0%.

The data should be good news for the Fed as it increases interest rates to tame inflation while not bringing the economy to a breaking point. October’s data supports a slowdown of rate hikes starting with a 50 basis-point hike at the Fed’s next meeting this month.

Still, the Fed still has work to do, the data showed.

On Wednesday, in a highly anticipated news conference, Fed Chairman Jerome Powell laid out the conditions that would spur a shift in the central bank’s policy. He cited three components of inflation as major factors: core goods, core services excluding housing, and housing services.

Less attention was paid to the housing component, even though it has contributed a significant amount to overall inflation. In recent months, most real-time indicators for housing prices and activity have shown sharp declines.

But that doesn’t mean the housing component in the inflation report will come back to normal anytime soon. On a three-month annualized moving average, housing inflation fell to 7.9% from 9%. Still, we estimate that housing inflation will not reach the pre-pandemic level until 2024.

The core goods component—which has contributed the most to elevated inflation—has shown significant moderation recently. Core goods inflation fell by 2.3% in October.

The main focus of the Fed, Powell said, is the component for core services not including housing, which has not signaled any slowdown and relies heavily on labor costs. That component increased by 3.7% on a three-month annualized moving average in October.

Looking at all three metrics, it is clear that inflation is still not under control, implying more rate hikes to come. In addition, we believe that any speculation around lowering the policy rate next year remains wishful thinking as inflation will most likely stay above the target level by the end of next year.

There is no reason to expect a rate cut if inflation remains elevated unless the unemployment rate runs out of control, crossing the 5% to 6% threshold.

Given the chronically tight labor market, we don’t think this will happen. Indeed, Powell said that holding interest rates could be a reasonable policy path next year, adding that he believes the impact of the Fed’s restrictive monetary policy will not cause heavy damage to job losses.

Personal spending and income

Spending was robust in October as holiday shopping started early for the second year in a row. Most spending categories rose on the month, with motor vehicles leading the way with a 5.8% increase from a month ago on an inflation-adjusted basis.

Excess inventories and savings were the two important tailwinds for such an increase in spending despite inflation concerns.

Consumers continued to draw down their excess savings as the savings rate dropped for the third month in a row to 2.3%. That brought down estimated excess savings to $1.1 trillion from $1.5 trillion in the prior month.

The other reason was strong income growth, driven largely by a tight labor market as companies competed on wages and benefits.

The Fed has signaled that it is watching income and wage growth closely because those measures are directly linked to service inflation, the stickiest component of inflation so far.

The takeaway

Relying on savings and inventories won’t bolster spending for too long. It is likely that this holiday season might be the last for a while with such a strong spending push. The full impact of the Fed’s restrictive monetary policy will not be felt completely until late next year.

There is still a lot for the Fed to do to bring inflation down as it focuses on rebalancing the labor market and wage pressures.