Spending Lags as Inflation Edges Higher

Personal disposable incomes rose 0.2% in May after adjusting for inflation. That marks a slight pickup from April but not enough to spur consumers on. Personal consumer expenditures were flat for the month. The saving rate, which remains suppressed, edged up slightly to 3.2%.

Spending on vehicles and nondurable goods was strong last month, tracking well with May retail sales. The only weakness occurred in spending on services, which contracted. We saw a sharp drop in spending on utilities as a cooler-than-usual May caused people to leave their air conditioners off; that should free up some spending for June. In fact, preliminary data on the Fourth of July holiday points to a new record for air travel with many taking the whole week, instead of just a long weekend, because the holiday falls mid-week. Discretionary spending is rising, which suggests a confident consumer.

The personal consumer expenditures (PCE) index rose 0.2% during the month, or 2.3% on a year-over-year basis. That marks the fastest overall inflation rate since March 2012 when energy prices were surging. The core PCE (excluding food and energy), targeted by the Federal Reserve as the most reliable inflation measure, rose 0.2%, edging up to a 2% year-over-year pace. That marks the first time since April 2012 that core PCE has hit the Fed’s 2% target.

The Fed has indicated that it will overshoot on its 2% inflation target - meaning it will tolerate a period of inflation higher than 2% - for two reasons: 1. Wages have not increased as much as Fed officials would like, which means they are willing to allow inflation to run a bit warmer if that allows more people to catch up from losses they suffered earlier in the cycle. 2. The Fed is concerned that inflation expectations have moved lower over the past year. Inflation expectations play a role in what employees demand and employers are willing to absorb in wage increases. The Fed’s goal is to avoid the low-to-no inflation and wages trap that Japan has endured for decades.

Bottom Line
Consumer incomes and spending are holding up well. The Federal Reserve will welcome the firming in inflation but prefers to see it accompanied by wage gains. Growth in the second quarter of 2018 will be robust but may not reach the hoped-for, 5% threshold.

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