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Consumers drain savings to spend

The outlier is spending on food; it has been trending down in real terms since August 2021.

Personal disposable incomes rose by an inflation-adjusted 0.2% in June, a slowdown from the upwardly revised 0.4% pace of May. Personal consumption expenditures rose an inflation-adjusted 0.4% in June, after increasing an upwardly revised 0.1% percent in May. The gap between income and spending was made up for by a drop in the saving rate to 4.3% in June from 4.6% May. Consumers have resumed taking on debt, despite much higher interest rates.

The pick-up in consumer spending was driven by a jump in spending on big-ticket items like vehicles, home furnishings and appliances. That likely reflects the pick-up in new home sales earlier in the year and is expected to wane in the second half of the year as credit conditions further tighten. Federal Reserve Chairman Jay Powell alluded to the additional tightening of bank credit conditions (details of which will be released on July 31) in his press conference following the July policy meeting.  Spending on nondurable goods rebounded after contracting in May, while spending on services remained steady. The outlier is spending on food; it has been trending down for the longest period on record after adjusting for inflation. The peak was in August 2021 as inflation surged. That said, spending on food soared relative to its long-term trend in the wake of the pandemic.

The personal consumption expenditure (PCE) index, the Federal Reserve’s favored measure of inflation, rose 0.2% in June, a slight acceleration from the 0.1% pace of May. The PCE slowed 3.0% on a year-over-year basis in June, a sharp deceleration from the 3.8% pace of May. Note: Overall inflation hit its high-water mark in June of last year, which is helping to dampen the jump in year-over-year measures of inflation.

The core (ex-food and energy) PCE index increased 0.2% in June, after rising 0.3% in May. That translates to a 4.1% annual increase, which is still double the Fed’s target, but a welcome cooling from the 4.6% pace of May.

The core services component of the PCE, which has proven the stickiest to date, rose 0.2% in June, the same as May. The year-over-year gains slowed to 4.1% in June from 4.5% in May. More importantly, the core services PCE slowed to 3.7% annualized pace in the second quarter from 5.1% in the first quarter. That is a better measure of the momentum in inflation, which is what the Fed wants to see.

The Fed would not declare victory after raising rates again in July and left the door open to additional hikes. More data like this could take another rate hike off the table. We will get two more reports on inflation before the September policy meeting.

Compensation gains cool

The employment cost index (ECI), which includes both wages and benefits, rose 1% in the second quarter. That marks a slowdown from the 1.2% pace of the first quarter and is the weakest pace since 2021 but still above the pace of 2019. That deceleration, coupled with a surge in compensation a year ago, helped to slow the year-over-year gain in the ECI to a 4.5% pace in the second quarter from a 4.8% pace in the first quarter.

Wages held up better than benefits on both a quarterly and year-over-year basis in the second quarter. Wages increased 4.6% from a year ago, while benefits increased 4.2% from a year ago. Health benefits in the private sector suffered the largest blow, with a slowdown to 2.1% on a year-over-year basis.  The great expansion of health care benefits for workers appears to be abating.

Year-over-year gains in compensation in the public sector outpaced those in the private sector for two quarters in a row. This is showing up in a surge in hiring at the state and local levels in recent months. They are finally able to compete more directly with the private sector. The catch-up in hiring in education has been particularly pronounced.  

The ECI is still running well above the 2019 average of 2.8%, which is closer to where the Fed believes compensation needs to go to ensure inflation hits its 2% target. A pickup in productivity growth would help to offset the spillover of compensation gains into inflation.

The good news for now is that inflation is cooling faster than compensation growth. That has pushed compensation gains above inflation for the first time since the first quarter of 2021, although it was only up 0.1% from a year earlier back then. Real compensation is growing at its fastest pace on a year-over-year basis since the second quarter of 2020, when many prices cratered in response to lockdowns.

That is good news as long as the acceleration in spending doesn’t reignite the cooling embers of inflation.

Bottom Line:

Inflation is cooling more rapidly than compensation gains. That has started to restore some of the purchasing power lost to inflation in recent years. If those shifts do not trigger a reacceleration in inflation, the Fed will be able to pause. It left the door open to an additional rate hike. We will need to see more of an improvement in the next couple of months before the Fed fully closes that door, but we are moving in the right direction. The probability of another hike fell on this data.


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Diane C. Swonk
Chief Economist, KPMG US

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