Consumers Spend Despite Higher Prices

The personal consumption expenditures (PCE) index of inflation rose 0.6% in January from December and surged 6.1% from a year ago. That is slightly less than expected; prices for nondurable goods and in the service sector decelerated, while prices on big-ticket durable goods accelerated during the Omicron wave. Core PCE, which strips out food and energy prices, rose 0.5% in January and was up 5.2% from a year ago. That is the hottest pace of core inflation since April 1983 and more than double the Federal Reserve’s 2% target.

Both inflation measures are poised to move much higher in response to Russia’s invasion of Ukraine in February. Oil and gas prices rose ahead of the invasion. It only takes two to three weeks for changes in oil prices to show up at the gasoline pump. Those increases will spill over into transportation costs and other prices in the service sector, which are expected to rise more rapidly as consumers return to in-person activities. Throughput at TSA checkpoints exceeded January 2020 benchmarks in February, while reservations and walk-ins at restaurants rebounded along with hotel room occupancies. Bookings for spring breaks have soared, with some resorts already sold out in early April.

The surge in inflation due to Russia’s aggression complicates the calculus for the Fed because it boosts inflation at the same time it takes a toll on demand. The Fed now appears to be betting that the turbulence the invasion has triggered in financial markets could do some of the heavy lifting on a tightening of credit conditions for them. That could push the Fed to move only a quarter, instead of one-half of one percent in March, but the Fed is still expected to raise rates by three-quarters of one percent by June. The risk of stagflation, a much worse outcome than inflation, has increased globally in response to Russia’s aggressions.

Personal disposable incomes fell 0.5% after adjusting for inflation in January, the sixth decline in a row. Those losses and the surge in prices did not deter consumers from spending on big-ticket durable goods.

Consumer spending rebounded 1.5% in January after adjusting for inflation. Revisions for November and December roughly offset each other. Spending on big-ticket durable goods accelerated with a surge in deliveries. Backlogs on everything from vehicles to furniture and appliances built up in the second half of 2021. That is creating a tailwind for spending on big-ticket items in early 2022. Spending on services slowed in response to the Omicron wave in January.

The saving rate plummeted to 6.4% in January, a pandemic low and well below the 7.2% pace of saving we saw prior to the crisis in February 2020. Consumers still have more than $2 trillion in excess savings from the pandemic and stimulus checks. Most of those gains are concentrated in high income households. Low income households are expected to quickly deplete their excess reserves as escalating rents and rising costs at the gas pump take a bigger bite out of their paychecks in the months to come.

Separately, the consumer sentiment index for February fell to 62.8, its lowest level since 2011. Attitudes improved a bit from the lows at the start of the month but that was before Russia’s invasion of Ukraine and the flare in oil prices. Expectations for inflation came down a tick but remain elevated both 1-year and 5-years out. That should worry the Federal Reserve.

The gap between the two most quoted measures of consumer attitudes, the University of Michigan’s consumer sentiment and the Conference Board’s consumers confidence indices wided to a record high in January. That is because the sentiment measures are much more sensitive to inflation, while the confidence measures are more sensitive to labor market conditions. We have not had the labor market improving with a surge in inflation since the 1960s. There is no muscle memory for an economy that generates heat in prices.

Producers More Optimistic

Durable goods orders surged 1.6% in January after being revised up sharply for the month of December. Aircraft orders alone surged more than 15% during the month, after posting robust, double-digit gains during the last two months of 2021.

Core capital goods, which strip out the volatile aircraft and defense orders, rose 0.9% after upward revisions to late 2021 figures. That suggests that firms started the year with aggressive plans to add to their capital stock. Indeed, gains were concentrated in heavy machinery orders, which had been hampered by chip shortages in 2021. Orders for motor vehicles and parts fell after a strong end to 2021. Communications equipment, electronics and appliances also lost ground during the month.

Core capital goods shipments, which feed directly into the GDP figures, surged 1.9% in January after a strong end to the year. That suggests that investment should remain strong despite the Omicron wave. Large backlogs and shortages are pushing firms to ramp up, even as demand slows from the red-hot pace of 2021.

Bottom Line
The economy is expected to slow from a revised 7% pace in the fourth quarter to 1.7% pace in the first quarter. That is not far from what we thought before Russia invaded Ukraine. The real issue is the extent to which we see a rebound in growth given the headwinds created by the surge in oil prices in the second quarter.

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