Key Inflation Index Continues to Rise

The personal consumption expenditures (PCE) price index rose 0.5% in June, the same as we saw in May. The PCE jumped 4% from a year ago, also the same as in May. That marked the strongest year-over-year gain in the PCE measure of inflation, which the Federal Reserve targets, since 2008.

The core PCE, which strips out food and energy prices, rose 0.4% in June after a solid 0.5% rise in May. The core PCE rose 3.5% from a year ago in June, up a bit from the 3.4% we saw in May, and the strongest pace since 1991. Gains in used vehicle prices and a rebound in airline fares, hotel room rates and rental car fees accounted for the bulk of those gains. Federal Reserve Chairman Powell stressed how the rise in those prices appears more transitory than permanent, given bottlenecks triggered by the pandemic and the rush by consumers to resume travel and tourism. Those prices should moderate substantially as we move into the second half of the year and in 2022. If they do not, the Fed is prepared to end its asset purchases and raise rates in 2022.

Personal disposable incomes fell by 0.5% in June, the third monthly contraction. A waning of stimulus checks and the surge in inflation accounted for the drop. An expansion of the monthly child tax credit, which shows up as monthly checks, and another strong month for employment with close to a million jobs are expected to reverse the loss in incomes in the second quarter as we move into the summer months.

Consumer spending rose 0.5% after adjusting for inflation. That marks a reversal of the downward 0.6% drop in May. Gains were dominated by a pickup in spending in the service sectors, including travel, tourism, dining out and medical visits. The drawdown in retail inventories was particularly large in the second quarter, given the sharp drop in in the first quarter. Retailers say they are seeing everything from apparel to luggage and makeup snapped up, the minute it hits store shelves.

The key is the level of consumer spending in the second quarter, which was boosted by strong gains in the spring. Consumer spending surged at a 11.8% annualized pace in the second quarter, after adjusting for inflation. That matches the estimate in the real GDP data yesterday. We will be watching the source data for overall GDP closely for revisions as the overall measure came in somewhat softer than expected, with a rise of 6.5% in the second quarter. Consumers were not the problem.

It remains unclear how much the spread of the Delta variant will put a damper on spending gains in August. Consumers defiantly kept spending, even during a surge in outbreaks. We are learning to live with outbreaks and shift to online and deliveries to avoid contagion. Vaccinations should help to blunt the blow, despite the spread of the Delta variant.

Unprecedented fiscal stimulus has helped support spending because it has kept money flowing to consumer wallets. Supplements to unemployment insurance will come to an abrupt end during the first week of September, which could exacerbate an expected slowdown in spending in August. More than nine million workers were still receiving supplements to unemployment insurance in the week ending July 10.

The saving rate plummeted to 9.4% in June, the lowest level during the pandemic, as stimulus checks waned. We should see a rebound in the saving rate associated with expansions to the child tax credit for July. We expect the saving rate to fall back to precrisis levels in early 2022. A big question mark is whether consumers will attempt to save more than they had, post-pandemic, given the risk of additional disruptions to employment. Much of that saving behavior will depend on the course of outbreaks and how well we treat infections. There is work being done on vaccinations that may eliminate the need for boosters and do a better job of fighting off all variants, but we are not there yet.

Separately, the employment cost index rose 0.7% in the second quarter, after rising 0.9% in the first quarter. The employment cost index rose 2.9% from a year ago, a pickup from the 2.6% gain in the first quarter. Much of that increase can be attributed to base effects: Compensation costs slowed in the second quarter of 2020 at the onset of the pandemic. The rise in inflation more than offset the rise in employment costs on a year-over-year basis. The isolated nature of those gains in only a few firms meant that margins increased unevenly. A rapid adoption of technology, triggered by the crisis, is helping to mitigate the rise in wages for the largest firms. It is not blunting the rise in wage costs as much for small, mom-and-pop operations.

Wages and salaries dominated the gains, with 0.9% increase in the second quarter. That marks a slight slowdown from the 1% gain in the first quarter. Essentially, a record-breaking 2.8% pick-up in leisure and hospitality wages were partially offset by a similar sized drop in wages in the financial sector. A surge in bonuses in finance buoyed gains in the first quarter. Commissions, notably on vehicle sales, slowed with the pace of vehicle sales. Margins on vehicles rose in response to shortages. Wages and salaries jumped 3.2% from a year ago during the quarter after posting a 2.7% annual gain in the first quarter.

Benefit costs rose 0.4% in the second quarter, after jumping 0.6% in the first quarter. Benefit costs are up 2.2% from a year ago, which marked a slowdown from the 2.5% gain we saw in the first quarter. Benefit costs rose the most in the public sector, not in the private sector.

The Federal Reserve is anticipating the supply of labor to expand dramatically when schools reopen, unemployed people find new work and the supplements to unemployment benefits are removed. Fed officials will be watching closely to see if the surge in wages abates as more workers participate in the labor market in the fourth quarter. For the moment, the rise in wages looks to be a one-time reaction to the rapid reopening of the economy. Fed Chairman Jay Powell was quick to note that we are not seeing the kind of “wage-price spiral” that precipitated the stagflation of the 1970s. Back then, the overwhelming majority of workers received cost-of-living adjustments in their pay, tied to the CPI. Changes in the cost of living were baked into labor contracts.

The spread of the Delta variant could slow the improvement in employment, especially in the leisure and hospitality sector as we get into August. A pickup in vaccinations should help to mitigate outbreaks and any related layoffs as we move into the fourth quarter.

Bottom Line
Consumers spent, despite the crimp on incomes due to the flare in inflation and shortages they faced as the economy reopened in the second quarter. The saving rate was drawn down much faster than expected and could pose more of a headwind along with the spread of the Delta variant this summer. Consumers are learning to live with the virus and keep spending even as outbreaks occur.

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