May income, spending and inflation data points toward a consumer adjusting to a more challenging economic environment and should dampen talk of a rate cut by the Federal Reserve in July or September.
A cooling economy and one-time factors in income payments resulted in a sharp nominal decline of 0.4% in personal income and 0.6% in disposable income, which was off by 0.7% once adjusted for inflation.
Personal income excluding government transfers dropped by 0.1% as real personal spending fell by 0.3% on the month. All of these declines point to a second straight quarter of soft consumer expenditures.
Sharp spending declines took place in a wide range of categories, including motor vehicles and parts, gasoline, food services and accommodation, financial services and insurance, transportation services as well as food and beverages. These declines all underscored a weak month of consumer outlays.
On a three-month average annualized pace, personal spending once adjusted for inflation increased by 1.6%, which was made possible by nominal increases of 0.4% in wages, salaries and compensation.
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The savings rate fell to 4.5% from 4.9% as consumers dipped into savings to cover expenditures.
But with inflation rising and the main impact of tariffs still to show up in the data, one can see a decline in households’ ability to support spending and economic growth much above 1% to 1.5% growth in the current quarter.
PCE index
The personal consumption expenditures index, which is the Fed’s preferred measure of inflation, increased by 0.1% in the top line and by 0.2% in the core while advancing on an annual basis by 2.3% and 2.7%, respectively.
These figures do not support recent market talk of a July or September rate cuts. In fact, once we updated the RSM estimate of the Fed’s reaction function, this implies that the current Fed policy rate of a range between 4.25% and 4.5% is appropriate.
Should inflation accelerate, though, our model will begin tilting toward a rate hike as the balance of risks across the economy shifts toward a focus on price stability.
Underlying inflation continues to reside around 2.5% in the PCE policy variable and 2.8% in the core which is a better predictor of long-term inflation.
On a three-month average annualized basis, inflation increased by 2.2% and at a six-month interval it was up by 2.8%. The core was up by 2.7% and 2.9% using those same metrics.
The takeaway
U.S. household spending and income once adjusted for inflation turned negative in May as the cumulative impact of past inflation and a slowing economy dampened demand.
While income and spending dynamics were not positive, they are consistent with growth in a 1% to 1.5% range in the current quarter.
The inflation outlook is a bit less sanguine ahead of second half of the year when we expect tariff-induced inflation to show up in the hard data.
In addition, our model of the optimal policy rate in May tends to suggest that as inflation increases, the Federal Reserve will put a greater emphasis on preserving price stability. That view would push any prospective rate cut out until the end of the year at the earliest.
