January inflation and spending data implies more noise than trend

REAL ECONOMY BLOG | February 29, 2024

Authored by RSM US LLP

The Federal Reserve’s closely watched measure of inflation, the personal consumption expenditures index, continued to show strength in January, rising by 0.3% on the month and by 2.4% from a year ago.

We are not too worried about the strong inflation print because of all the seasonal factors involved. Housing prices also spiked in January, but that increase looked more like noise than trend.

Looking ahead to the February data, rising energy and gasoline prices might lead to another strong inflation number just as the Federal Reserve is about to hold its next meeting in March.

Still, we don’t expect any kind of sharp rebound that will change the Fed’s decision to cut rates this year.

We think housing inflation will cool down materially toward the summer and offset any increases in goods or energy inflation that have spurred concern.

If you look at the overall picture, there are many reasons to expect inflation to ease further when interest rates are this high and inflation expectations are well anchored. Although the economy has been running quite robustly, but it will eventually cool down.

Personal spending came in a lot slower at 0.2% in January compared with 0.7% in December despite the surge in personal income, which suggested a spending hangover from an unusual weather effect during the month. Adjusting for inflation, real spending dropped by 0.1% on the month.

Personal income rose by 1%, much higher than expected, mostly driven by government transfers like social security adjustments and dividend income because of the surge in equity prices.

We think there is a good chance that underlying PCE inflation can reach the 2% goal by midyear. For core PCE, we think we could settle around 2.5% at the same time.

The 2.4% increase for the overall year-over-year PCE figure was down from 2.6% earlier, while the core 2.8% figure represented a decline from 2.9% in December. We still have about five more months until the summer, and things look on track according to our predictions.

Policy implications

January’s data reaffirms our forecast from December that the Fed’s first rate cut will be around June. But over the past three months, the market jumped ahead of itself to price in rate cuts earlier than June. Now, the probability for the first cut in June according to the market is about 70%.

That is why we avoid changing our minds based on only a few data points, and we think the Federal Reserve is in the same boat. Fed officials are not going to rush to cut rates too early. By the summer, the Fed should have about one year of inflation data that supports a lower interest rate.

The risk, however, is now on the upside of growth given strong income growth and the wealth effect from the equity markets, which have surged another 6% so far this year. If the economy continues to outperform expectations, we might see fewer rate cuts than our baseline prediction of four this year.

The data

Overall inflation rose by 0.3% on the month with the core components rising by 0.4%. Goods inflation continued to stay in the negative territory, falling by 0.2%, while services inflation was the main driver of the uptick, rising by 0.6%.

The increase in services inflation was broad-based as most components posted increases. Housing inflation was the highest in almost a year at 0.6%.

Real spending fell by 0.1% as spending on goods registered a sharp 1.1% drop in January after rising by 0.9% in December. Services spending volume grew at the same rate of 0.4%, continuing to be the main support for overall consumption.

The significant increase in income was because of the 2.6% spike in government transfers and the 4.1% increase in personal dividends on the month.

As a result, the savings rate ticked up to 3.8% from 3.7% earlier. But that remained low compared to the pre-pandemic average.