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Incomes, spending and inflation sizzle

The surge in consumer spending was broad-based in both goods and services.


Personal disposable incomes jumped 2.0% in January, after rising 0.4% in December. An 8.7% jump the cost-of-living adjustment (COLAs) in Social Security payments alone added close to $109.7 billion on an annualized basis to those gains; that was the largest increase on record and nearly 50% higher than the next largest jump in those payments in 2022. The gains are being driven by both the COLAS and the sheer number of baby boomers now entering retirement.

Consumer spending rebounded at a 1.8% pace in January after falling 0.1% in December. Unseasonably warm winter weather added to those gains but does not explain the degree of rebound in spending we are experiencing. The boost in Social Security checks and retention of workers in January were larger factors in supporting those gains.

The saving rate continued to rise to 4.7% in January from an upwardly revised 4.5% in December. Anecdotal reports suggest that consumers were able to better manage their credit card balances due to a surge in incomes in January.

The surge in consumer spending was broad-based in both goods and services. Spending on vehicles, appliances, home furnishings and travel all picked up. The number of people out on vacation and unable to work in January exceeded the already high levels of December. Those gains continued in early February, with TSA throughput data exceeding 2019 levels many days during the month. 

Spending on medical services also increased. Backlogs at doctors' offices remained large, while the demographics of aging, ailments not treated during the pandemic and long COVID continued to stress the limits of hospitals. 

The only major outliers were spending on gasoline and utilities, which fell after adjusting for inflation. Unusually warm weather and disruptions triggered by flooding across the largest state, California, added to that weakness. Extreme weather events are rising in frequency and ferocity. 

The problem for the Federal Reserve is inflation, which picked up in January after being revised up in late 2022. The personal consumption expenditures (PCE) index jumped 0.6% in January, three times the upwardly revised pace of December. A pickup in prices at the gas pump and sky-high egg prices contributed but did not explain all of those gains. Year-over-year gains in the index rose to 5.4%, a tick above the upwardly revised pace for December. That was despite a surge in inflation a year ago, which should be making year-on-year comparison easier, not hotter. 

The core PCE index, which strips out food and energy, rose 0.6% after rising 0.4% in December. That translates to an acceleration in year-over-year core inflation to 4.7% from an upwardly revised 4.6% pace of December. The concern going forward is twofold for the Federal Reserve: 

  1. Goods prices, which were expected to continue to cool, have started to rise again. Wholesale prices for used cars have spiked, which will show up as more inflation this spring; and 
  2. The service sector, which accounts for more than half of the PCE index, is accelerating. That ups the risk of inflation becoming entrenched.

We now expect the fed funds rate to hit at least 5.75% in 2023 and stay there the entire year.

The core services PCE index, which strips out shelter costs, and is closely watched by the Fed, jumped 0.6% in January, the highest since November 2021. That marks an acceleration over the upwardly revised 0.4% pace of December. That translates to a 4.6% increase versus 4.3% in December. The annualized pace of core services, which tracks momentum in inflation, showed a sharp 7.4% acceleration over the 5.2% pace of December.

The core services PCE accounts for more than half of the overall PCE index. The move up we are seeing is the Federal Reserve’s worst nightmare, as it suggests underlying inflation may be rebounding. Those prices are more dependent on labor market shifts and are why the Fed is so focused on raising unemployment and cooling wage growth. The fear is a more persistent and corrosive bout of inflation taking root.

Bottom Line

After showing signs of cooling in late 2022, incomes and consumer spending came roaring back in January. Unseasonably mild winter weather amplified but did not fully explain those gains. The resilience of the consumer and accompanying acceleration in inflation are red flags to the Fed. They have little choice but to raise rates by half a percent at the meeting in March. Brace yourself for a call for rate hikes by some members to hit 6% or higher at that meeting. We now expect the fed funds rate to hit at least 5.75% in 2023 and stay there the entire year. 

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Meet our team

Image of Diane C. Swonk
Diane C. Swonk
Chief Economist, KPMG US

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