The Federal Reserve’s preferred measure of inflation continued to ease in May as the personal consumption expenditures Index remained unchanged on the month and rose by 2.6% from a year ago.
The core PCE index, which excludes the more volatile food and energy components, advanced by 0.1% and increased by 2.6% year over year, the Commerce Department reported on Friday.
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Taken out to three decimal points, the Fed’s policy variable now stands at 2.563%, which is within shouting distance of its 2% target, suggesting that it will soon be appropriate for the central bank to relax its restrictive policy stance and cut rates.
While we would be comfortable with the Fed putting a rate cut on the table at its July meeting, it is probable that will not happen until September.
The flat reading in inflation was driven by a 0.1% decline in goods prices with a 3.2% drop in durables and a modest 1.6% increase in non-durables.
Service sector inflation increased by 3.9%, which is down from 4% in April. Food prices increased by 1.2% in May while the energy index advanced by 4.8%.
Just as important, the upside surprise in May’s job creation showed up big in the personal income number, which rose by 0.5% on the month. That increase was driven largely by wage and salary growth that was up by 0.7%, followed by dividend income, which was up by 0.5%.
With inflation coming in flat, disposable income growth on an inflation-adjusted basis also posted a strong gain, rising by 0.5% in May.
With excess savings built up during the pandemic likely dried up by now, strong income growth has been one of the key tailwinds for spending to remain solid. Spending rose by 0.2% from a month ago, and by 0.3% after inflation is accounted for.
That rise was a much-needed rebound for the second quarter after a disappointing April. Still, on average, spending growth in the first two months of the second quarter was around 1.3% to 1.5% on an annualized basis, not enough to guarantee a strong rebound in gross domestic product for the second quarter.
We expect the payroll report next Friday to post a slower pace of job gains, and as a result, that easing should cool income growth in June. That means it is hard to find any reason to expect personal spending to grow faster.
If that turns out to be true, we think GDP growth in the second quarter should be closer to 2% instead of the 2.5% that we currently have as the base case.
Under the top line, and on an inflation-adjusted basis, spending grew most for recreational goods and vehicles, rising by 2.6% on the month, followed by transportation services, which increased by 1.4%.
Most of the other components posted modest gains except for spending on food, housing and motor vehicles, which showed slight drops.
The takeaway
Personal disposable income and overall income increased by 0.5% in May, which bolstered the savings rate that increased to 3.9%. Spending continued to cool, increasing by 0.2%, and is now advancing at a sustainable 1.5% on a three-month average annualized pace. That pace will translate into easing demand for services, which will feed into further cooling in overall inflation.
With overall inflation now just fractionally above the Fed’s 2% inflation target, we would expect that conditions are slowly moving into alignment to support the relaxation of the Fed’s restrictive policy stance at its September meeting.
