Consumers Lose Momentum
The strength of the labor market is key to what happens next.
Personal disposable incomes rose 0.2% after adjusting for inflation in December. That follows revisions that netted out to the upside for October and November, which means consumers ended the year with more income in their wallets than initially reported.
However, those gains did not feed into stronger consumer spending, which was revised down dramatically in October and November and contracted by 0.3% after adjusting for inflation in December. Large declines in spending on goods, except for gasoline (travel within the U.S. was up), drove those declines. Spending in the services sector was mixed, with gains in travel and healthcare offsetting losses at restaurants, financial services and in insurance. People were more interested in spending time with family over the holidays than stepping out, either to entertain or travel abroad.
The loss in momentum over the quarter showed up in large, upward revisions to the saving rate, which bottomed out in September. The saving rate is at its highest level since May. That suggests that consumers are either reluctant and/or unable to tap the massive reserves that they accumulated during the pandemic. Consumers started 2022 with nearly $2.3 trillion in excess savings; they ended the year with less than half that. Much of the remainder is now concentrated in higher income households, which are less likely to tap those reserves especially in the wake of the drop in asset prices. Financial assets and home values fell during the year.
The tailwind on spending associated with the surge in pandemic home buying has died down. Home remodeling has held up better, as those who were forced to delay repairs and remodeling when material prices soared have moved forward in recent months. There are some signs that the housing market may be bottoming. That is both a blessing and a curse if it puts a floor under shelter costs and triggers another surge in spending on big-ticket vehicles and housing-related goods, which have fallen the most in price.
The weakness in December sets the stage for more of a slowdown in spending at the start of 2023. The extent of that weakness will hinge on consumer attitudes and their willingness to tap their saving and the persistence of a strong job market. Fears of recession may have prompted some to pull back more than expected during the holiday season. The strength of the labor market from here on out is key to what happens next.
The labor market outlook depends on the trajectory of inflation and how aggressively the Federal Reserve continues to fight inflation. The Fed has doubled down on its commitment to raise rates at least another 0.75% by May and hold them at that level the entire year.
The personal consumption expenditures (PCE) index of inflation rose a tepid 0.1% in December with a drop in prices at the gas pump and discounting on vehicles and furniture more than offset by a rise in service sector prices. The PCE index cooled to a 5% year-over-year pace from 5.5% in November. PCE inflation cooled to a 3.2% annualized rate in the fourth quarter after rising at a 4.3% pace in the third quarter.
The core (excluding food and energy) PCE index rose 0.3%, after cooling to a 0.2% pace in November. Core PCE was up 4.4% from a year ago, after a 4.7% pace of November. The core PCE rose at a 3.9% annualized pace in the fourth quarter, still nearly double the Fed’s 2% target.
The Federal Reserve’s new flavor of the month, the core PCE services (excluding shelter) index, increased 0.3% in December, the same as November. The core services index also rose 4% from a year ago in December, a slowdown from the 4.3% pace of November. The problem for the Fed is the annualized pace of core services inflation in the fourth quarter, which accelerated to a 4.7% from a 3.5% pace in the third quarter.
The Fed has cautioned against making too much out of a three-month downdraft in inflation, as that occurred and then reversed itself in 2021. Fool me once, shame on you...
The Fed is watching the core services (ex shelter) index more closely because of the outsized role that labor costs play in setting service sector prices. It fears that ultra-tight labor market conditions could place too high of a floor under wages and inflation. Hence, the focus on raising rates enough to stall the economy with persistently higher inflation-adjusted rates. The goal is to better align labor demand and supply with a reduction in demand and increase in supply via higher unemployment.
Economic momentum slowed as we moved into the end of the year. That shift set the stage for weaker consumer spending at the start of 2023 but did not fully derail inflation. The Fed is expected to stick to its current trajectory for three more quarter-point hikes by May. We need to see core inflation slip convincingly below 3% for the Fed to pivot and cut rates.