Inflation Hot, Spending Not

Personal consumption expenditures (PCE) plummeted 1% after adjusting for inflation in December, while incomes fell another 0.2% during the month. The saving rate moved up to 7.9%, more than one half of one percent above the rate of savings before the onset of the pandemic in early 2020. Consumers still have more that $2 trillion in excess savings they amassed during the pandemic, but it remains unclear how and whether they will spend it: Much of that saving is concentrated in higher income households who spend their incomes, not their savings. Some saving will be allocated toward supporting retirement.

Data for the previous two months was revised up for both spending and incomes but not enough to offset the sharp drop in December. Real GDP growth in the fourth quarter, which came in at a 6.9% annualized pace yesterday, could be revised down a bit once the data is updated for the quarter next month.

Consumers pivoted back into services, including travel, tourism and health care over the month as they opted to see their loved ones instead of buying traditional holiday gifts. Spending on goods of all types contracted over the month.

Inventories rose but not enough to alleviate shortages of vehicles, appliances and just about everything that requires computer chips. Vehicle producers were forced to curb production again in January in response to what have become acute chip shortages.

Much of the strength we saw in consumer spending in the fourth quarter GDP figures released yesterday was front-loaded into October. Many have argued that those gains represented an effort by consumers to buy ahead of shortages during the traditional holiday season. Missing in that explanation is that consumers were also catching up on spending after a lull during the Delta wave last summer. Inflation looks like it took an even larger bite out of what many households could afford to spend during the holiday season.

The personal consumption expenditure (PCE) index, the Federal Reserve’s favored measure of inflation, rose 0.4% in December and surged 5.8% from a year ago. That marks the hottest annual pace of PCE inflation since mid-1982.

Gains in prices were broad-based in both goods and services. Energy prices posted a temporary setback, but have since moved even higher in response to tensions between Ukraine and Russia. Russia could curb its exports of natural gas to much of Europe if tensions further escalate. Politico has a chilling scenario today of how a hot war between the U.S. and Russia could unintentionally trigger the use of nuclear weapons.

The core PCE (ex-food and energy) index rose 0.5% in December and jumped 4.9% from a year earlier. That marks the fastest pace of core PCE inflation since 1983 and is one of many reasons the Federal Reserve has taken note and is willing to combat inflation with rate hikes and reductions in the still-bloated balance sheet. The preference is to rid the Fed of its holding of mortgage-backed securities to alleviate the role the Fed has in picking winners and losers: in this case, housing. Mortgage rates have already picked up and are dampening first-time buyer demand along with skyrocketing prices. Speculators, who are flipping to rent instead of sell, continue to snap up properties unseen for cash.

Spending is likely to soften again in January in response to the Omicron wave. Both spending and paychecks have been affected. Open Table reservations and walk-ins showed a sharp slowdown relative to the 2019 baseline in January. A similar pattern was seen in box office revenues, hotel room occupancies and throughput at TSA lines. This is at the same time that initial unemployment claims jumped in response to Omicron-induced layoffs and store closings.

Separately, the employment cost index (ECI), which tracks wages and benefits costs, rose 1% between the third and fourth quarters. That is marginally slower than the 1.3% surge we saw in the third quarter but still marks an acceleration in compensation from a year ago. The overall ECI jumped 4.0% from a year ago in the fourth quarter, the strongest pace in two decades.

Gains in the private sector continued to outpace gains in the public sector, although both accelerated. Public schools have had a particularly hard time staffing up. An inability to compete with the private sector is exacerbating those problems. This is despite the pile of cash many school districts are now sitting on due to the cost saving associated with the pivot from in-person to online classes and surge in real estate tax revenues over the last two years.

Finance was an outlier with compensation in credit intermediations - traders and investment bankers - jumping nearly 6% from a year ago. That marked a moderation from the 8.5% annual pace we saw in the third quarter but is still stunning. Wages in that sector were up at a double-digit rate from a year ago in the second half of 2021, which is well above any measures of inflation. This explains complaints by the major banks regarding margin compression in the fourth quarter and begs the question of whether we are beginning to see the first signs of wage-push inflation.

One has to wonder how well those wage gains will hold up as the Federal Reserve moves to raise rates and deal flows dry up. The only sector that came close to those kinds of wage gains in the last 20 years was wages in information. They hit an annual peak of 6.4% in the first quarter of 2015.

Wage gains far outpaced gains in benefit packages, although costs of both are rising. Pet insurance has become popular. That said, low-wage employers scaled back on paid sick leave for workers who were exposed to COVID in response to the CDC’s decision to shorten quarantines in January. Many workers had to tap paid vacation days or lose a paycheck entirely during the Omicron wave in January. One worker I know was forced to tap into next year’s vacation to cover the time he was out sick and still testing positive, despite being boosted.

The preliminary read on consumer sentiment came in at the lowest level in a decade in January. The Conference Board measures of confidence, which came out earlier this week, also deteriorated but held up better during the month. The Michigan survey is more sensitive to inflation, while the Conference Board survey is more sensitive to shifts in the labor market. The gap between the two measures remained near a record high in January. That said, we can’t rule out a contraction in employment during the month. Initial unemployment claims picked up with layoffs in the service sector during the month.

Bottom Line
Inflation is beginning to bite and suppress spending and consumers’ assessments of the economy. Federal Reserve Chairman Jay Powell delivered a much more hawkish tone at the press conference following the FOMC meeting. It is past time; panic within the Fed’s ranks has begun to set in. The challenge now is to tamp down inflation without allowing the flame on the overall economy to go out. There is no road map for doing this after inflation has surged.

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