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Economic Commentary

Strong consumer spending adds to inflationary pressures: Weekly Economic Review & Outlook

February 27, 2023
Illustration of woman purchasing items at a retail store

The strong employment gains in January resulted in a jump in personal income and consumer spending last month. This led to faster, broad-based inflation that raises the likelihood that the Fed will raise rates beyond its previous estimates. Also, home sales activity remained subdued due to poor affordability and a low supply of existing homes for sale.

Key Takeaways:

What we learned last week: (pg. 1)

Core inflation picks up

Core inflation, led by price gains for services, picked up in January after three straight months of decline.

Total home sales steady at a very low level

Even during a very strong month for new home sales, the pace of total home sales was near an 11-year low.

What we’re watching this week: (pg. 2)

February 28: Consumer Confidence

Strong labor market to boost consumer confidence

Nonfarm payrolls rose at their fastest pace in six months in January which should boost consumer confidence in February, lifting the consumer confidence index slightly to 109 from 107.1 in January. While still-elevated inflation burns a hole through the consumers’ pockets, the sharp rise in real personal spending in January demonstrates the resilience of spending behavior and supportive current conditions for many households.

March 1: ISM Manufacturing

ISM manufacturing stays in contraction

The ISM manufacturing index is expected to see a slight uptick in February but should remain in contractionary territory. The current streak of five consecutive declines for the index reflects the slump in demand for goods and, consequently, manufacturing production. We expect some stabilization for new orders and production in February, with the overall index climbing to 48 in February from 47.4 in January, but this would still be consistent with a modest contraction for the sector.

March 3: ISM Services

ISM services expected to fall, but remain in expansion territory

The service sector grew in January following the first contraction reading in December since May 2020. While growth should ease slightly in February, we still expect solid expansionary conditions for service industries. Business activity and new orders within services rebounded sharply in January after declines in December and should remain sturdy in February. The hot labor market continues to spark consumer demand for services and should keep new orders strong and resilient. We look for the overall ISM services index to fall slightly to 54.4 from 55.2 in January.

Analysis: Acceleration in consumer inflation increases the odds of further Fed action

Robust spending and income for January was in line with other strong economic data for the month, showing renewed economic vigor despite the Fed’s efforts to cool inflationary conditions. Personal consumption expenditures (PCE) climbed by 1.8 percent in January, the largest gain since March 2021 — when spending was boosted by Covid-related stimulus checks. After two straight month-over-month declines, spending on durable goods surged in January despite high borrowing rates. While spending on services picked up as well, it did not drive spending gains for the first time in three months.

The spending jump was fueled by continued strong demand for labor that led to the stunning 517,000 rise in employment in January, increased hours worked by existing workers, and continued buoyant gains in wages. While overall personal income showed a smaller-than-expected increase of 0.6 percent for January, disposable personal income (less taxes) jumped by 2.0 percent — a significant shot in the arm for consumer spending power in early 2023. It also helped lift the personal saving rate to 4.7 percent from 4.5 percent in December and up from a recent low of 3 percent in August.

The strong gains in consumer spending and income in turn boosted core services inflation. The PCE price index climbed 0.6 percent in January, lifting the 12-month trend rate to 5.4 percent from 5.3 percent. The 12-month change in the core PCE index (the Fed’s preferred measure of inflation) also ticked up from 4.6 percent to 4.7 percent, far above the Fed’s two percent goal. Even the “super” core inflation measure (core services excluding housing — a recent favorite of Fed Chair Powell) accelerated to 4.4 percent from 4 percent in December, suggesting the price gains were broad-based and not just spurred by rising housing costs.

Under normal circumstances, January’s spending would be celebrated as a sign of robust consumer activity and continued economic expansion. But, given the Fed’s current primary focus of achieving price stability, the steamy data raise the odds of more tightening from the Fed and, consequently, a likely hard landing for the economy. We now see the terminal fed funds rate rising to a 5.25-5.50 percent range by mid-year. If the February data continue to report ebullient economic activity and importantly if inflation refuses to slow materially, the Fed might increase the size of the next rate hike back to 50bps on March 22 after dialing it back to just 25bps at the last meeting on February 1.

New home sales spike, but total home sales still very low

Home sales were a mixed bag in January. Existing home sales declined for a 12th straight month, falling to their lowest level since 2010. New home sales, on the other hand, surged to their highest level since March — but new home sales are more volatile and prone to large revisions. That said, January’s fast pace for new home sales and the upward revision for December show that the market for new sales is faring better than for existing sales. This suggests that new sales are still benefitting from the very low inventory of existing homes, pushing prospective buyers into the market for new homes. However, the renewed upward climb in mortgage rates likely dampens demand for new homes as well.

Given that the majority of home purchases consist of existing homes, total home sales (new plus existing) in January were only a tick higher than December’s 11-year low. Moreover, the recent sharp decline in mortgage applications for purchases tempers expectations for the upcoming spring selling season.