Government data released Friday indicates that the Federal Reserve will need to keep its foot on the gas pedal: while inflation data came out slightly better than expected, the key wage inflation metric—the employment cost index—remained elevated, according to the Labor Department. On top of that, spending was much better than expected in September, with an upward revision from August. That means the economy can absorb more monetary tightening.
The personal consumption expenditure price index was unchanged at 6.2% in September from a year ago, while core inflation rose to 5.1% from 4.9%. That should likely push the Fed to bring its policy rate to above 5% by the first quarter of next year.
Our rule of thumb is that the policy rate should always be above the year-over-year core PCE inflation number to get ahead of the curve. A 75-basis-point rate hike in November is pretty much a done deal. We expect the Fed to slow down in December with a 50-basis-point hike.
The employment cost index increased 1.2% in the third quarter, down 0.1 percentage points from the prior quarter. While that was the second 0.1 percentage point decline in a row from the recent high of 1.4% in the first quarter, the sluggish pace of wage moderation remained a problem, especially when another pay raise cycle is approaching.
Less bargaining power for employers
Workers often get promoted or switch jobs around January, July and August, which mark the end of a calendar year and the end of a fiscal year, respectively. With sticky inflation in mind, workers would mostly likely work rising prices into their contracts for promotions, causing wages to grow even more. Employers, who are facing a tight labor market, should have less bargaining power even when we might be approaching the end of the business cycle.
The reason is that even if we descend into a recession—and our estimate is that there is a 65% probability of a recession over the next 12 months—we think it will be a shallow one, mostly due to the Fed’s rate hike campaign. Therefore, we don’t expect any spike in the unemployment rate similar to what we saw during the Great Financial Crisis or the pandemic.
Our baseline for the unemployment rate next year is around 4.7%, only slightly higher than the natural rate of unemployment at 4.4%. That means businesses will have to hold on to their workers a lot longer than in previous business cycles as labor supply remains sticky while the participation rate has been close to a full percentage point lower than the pre-pandemic level.
The rebound of personal spending was not a surprise, based on our earlier forecast both in nominal and real terms. Spending rose 0.6% and 0.3% after adjusting for inflation. Together with the upward revision to August’s number, American consumers continued to be resilient in the face of elevated inflation in the third quarter.
One factor that drove strong spending was an increase in income growth. Personal income rose 0.4% in September. August’s reading was also revised upwardly to 0.4%. That again highlights the impact of a tight labor market, which implies good and bad news at the same time.
Also, saving rates declined further in September to 3.1%, the lowest level since 2008. That suggests consumers are saving a lot less to keep their spending up likely due to the cushion of excess savings accumulated during the pandemic. We expect spending to remain solid in the last quarter as inventories and a strong dollar stay as tailwinds.
However, spending should slow down significantly after the year ends, with the holiday hangover and as savings continue to dwindle. Next year, the economy will turn its pace and enter a new era of slower growth, marked by a likely mild recession and restrictive monetary policies.
