The likelihood of a 50 basis-point rate hike by the Federal Reserve in May increased on Thursday as the government reported that a key inflation gauge continued to surge in February. The data for the personal consumption expenditures price index came as another strong jobs report is expected on Friday.
The PCE price index—the Fed’s key gauge for inflation—rose by 6.4% from a year ago, the highest in 40 years.
The PCE price index rose by 0.6% month-over-month in February, and by 6.4% from a year ago, the highest in 40 years.
Rising inflation cut into consumer income and spending on the month as spending volume and income purchasing power declined, the Bureau of Economic Analysis reported.
Spending increased by 0.2% in February but declined by 0.4% after adjusting for inflation. Personal income told the same story, rising by 0.5%, but falling by 0.1% on an inflation adjusted basis.
There is no question that the Fed will keep raising rates this year, but we expect the approach to be methodical as it continues to process new data.
Given the recent volatility in the oil market and the Biden administration’s aggressive moves to stabilize oil supplies by using the strategic petroleum reserve, the Fed won’t likely steer away from its course.
Setting market expectations and sending clear guidance are as important as raising rates in keeping inflation under control. The Fed has been quite successful in doing so, avoiding adding more uncertainties to the market.
Chairman Jerome Powell, for example, signaled 10 days ago the possibility of a 50 basis-point rate hike and the start of a balance sheet runoff in May.
The price index, however, reflected only some of the Ukraine war’s impact as oil and other commodity prices began to rise in late February. The full impact will be felt in March, most likely driving the headline PCE even higher.
The core PCE, which excludes food and energy, showed signs of price gains easing, rising by only 0.4% month over month from January’s reading of 0.5%. Compared to the low levels of a year ago, core PCE rose sharply to 5.4% from 5.2%.
We have discussed in a recent note that the pass-through effect of rising oil prices on core goods and services won’t likely be as severe as in the past. In fact, rising oil and commodity prices are in a sense forcing consumers to ration their spending, effectively reducing their spending on core goods and services.
Note that the PCE price index is a better indicator for inflation than the consumer price index because it takes into account the substitution effect of consumers switching to lower cost goods. Also, the PCE price index includes goods and services that a typical consumer does not have to directly pay for, like medical insurance, which is paid for by employers.
Recession is unlikely
Two causes for concern in the outlook are the decline in real spending and income in February, when most of the impact of the Russian invasion of Ukraine had not been absorbed yet, and a temporary inversion of the two-year 10-year yield curve for the first time since 2019, which can be a recession indicator.
But there still is a lot of room for the economy to grow even when rate hikes keep coming. The Fed is banking on the strong labor market, and robust household and corporate balance sheets as the reasons for continuing growth.
Consumers seem to be spending down their excess savings accumulated during the pandemic as prices remain elevated and fiscal support has waned. The savings rate has trended down to below the pre-pandemic level, staying at 6.3% in February.
Spending on services remained subdued in February, staying flat on an inflation-adjusted basis compared to spending on goods, which was down 2.7%. We should expect more spending on services in the next couple of months as summer approaches and travel restrictions continue to be lifted.
Real spending on services has not recovered fully to its pre-pandemic level in 2019. This will be another source for optimism on economic growth.