A robust 0.4% increase in personal spending and a 0.6% increase in personal income in October underscore just how strong the economy and households have been ahead of the critical holiday spending season.
But at the same time, the strong spending and income data, released on Wednesday by the Commerce Department, points to sticky service sector inflation that will play a much larger role in the economy ahead of expected higher tariffs next year.
The totality of the spending, income and inflation data supports a 25 basis-point cut at Federal Reserve’s next policy meeting on Dec. 18.
But this same data, combined with the arrival of significant policy changes on trade next year, will all contribute to what we think will be a pause in rate cuts early next year.
We do not expect a rate cut at the Fed’s January meeting. The first possible date for another rate cut will not be until the March meeting, where we will get the Fed’s next Summary of Economic Projections, which will reflect the new trade policies and an expected expansionary fiscal policy.
PCE data
Inflation is proving to be quite stubborn as the Federal Reserve tries to bring it back to its 2% target.
In October, the personal consumption expenditures price index increased by 0.2% on the month and by 2.3% on a year ago basis. Core PCE, which excludes the more volatile food and energy components, increased by 0.3% on the month and by 2.8% from a year ago.
While there were one-time factors that will not be repeated like the 1.3% increase in financial dividend payments, which is the highest since March, that increase stands in contrast with the 1% decline in the price of goods and the 3.9% increase in service prices.
The inflation mix will continue to challenge a Federal Reserve that wants to reduce its restrictive policy stance but cannot ignore stubborn service-sector inflation.
One thing is certain: Given what may be a sharp increase in tariffs, policymakers, investors and firm managers will be paying close attention to both the PCE price index, which is the Federal Reserve’s preferred measure of inflation, and the core PCE, which offers a better long-run look at inflation trends.
The ripple effect of tariffs
Changes in trade policy will affect the cost of imported goods through the North American auto manufacturing supply chain. Disinflation through the import channel on goods has driven down inflation over the past two years.
But higher goods costs are most likely on the way, and that increase will also result in higher service-sector costs.
So how does this work?
The best example of how an increase in tariffs translates to higher inflation is to look at motor vehicle parts and their link to auto insurance prices.
Tariffs on auto parts would raise the cost of vehicle repairs, which would then result in higher insurance costs, which have already risen by 36% since 2020.
Read more of RSM’s insights on the economy and the middle market.
For each percentage-point increase in tariffs on total imports, one should expect a 0.7% increase in the PCE price index with the risk of a greater increase considering the significant policy changes under consideration.
Those dynamics pose a modest risk to our forecast of a 2.5% growth rate in gross domestic product next year and our estimate of an average 2.2% PCE inflation rate.
The takeaway
American households remain financially strong as income dynamics support robust spending ahead of Black Friday and the critical holiday season.
Those dynamics are contributing to the sticky inflation in the service sector, though it is abating.
The dynamics also support our call for a 25 basis-point rate cut at the Fed’s policy meeting next month. But given the looming fiscal and trade policy changes, it is growing more likely that the central bank will pause its rate-cutting campaign to ascertain their impact on the economy.
