The major takeaway from the release of the January personal consumption expenditures index on Friday is an acceleration of inflation in the service sector, which makes up most of the American economy, to 3.5% because of turn-of-the-year price increases.
On a month-over-month basis, the top-line PCE index, which is the Federal Reserve’s preferred measure of inflation, increased by 0.3%, with the core rate excluding food and energy rising by 0.4%. Those increases translated into gains of 2.8% and 3.1%, respectively, on an annual basis.
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The data, though, was collected before the outbreak of war in Iran and the surge in energy prices. Forward-looking investors, policymakers and executives should anticipate sharp increases in the March data. Like the recent consumer price index, we expect the top line to increase to between 3.5% and 4% by midyear.
Inflation-adjusted spending in January increased by a modest 0.1%, which takes the bloom of the rose of the 0.4% increase in nominal income and spending.
Service sector pricing is sticky and rising. That is clearly what is driving core inflation, which is the best predictor of longer-run pricing.
For the Federal Reserve, service sector inflation was already a pressing problem, even before the energy shock now working its way through the U.S. economy.
Any idea of a near-term rate cut by the Fed should be sidelined. The central bank will choose to wait and see if top-line volatility caused by the energy shock bleeds through to core prices and pushes up inflation expectations.
The data
Goods inflation over the past year increased by 1.3%, with durables rising by 2.2% and non-durables advancing by 0.8%. Services were up by 3.5% while food prices increased by 2%.
Energy costs in January declined by 0.8% which will see a significant increase in the March data.
Compensation, wages and salaries advanced by 0.5%, disposable income was up by 0.9% and the savings rate increased to 4.5%, all on a nominal basis.
In addition to inflation-adjusted personal spending increasing by 0.1%, personal income excluding government transfers was up by 0.2% and disposable income increased by 0.7%.
The takeaway
One can observe turn-of-the-year price increases in the service sector, where inflation rose by 3.5% and is fueling the anxieties that underscore what the public identifies as an affordability crisis.
Those increases will be exacerbated as the energy shock, fuel surcharges and rising gasoline prices are felt in utility bills, at gas stations and at checkout lines.
We expect that both the top-line CPI and PCE indexes will move to or above 3.5% because of the combined impact of sticky service prices and rising energy costs.
The major questions that need to be answered:
- How will this affect short- and medium-term inflation expectations?
- Will top-line energy costs bleed through to core prices?
- How will the Fed respond if both occur?
We expect the Fed to temporarily look through volatility energy costs. But should those inflation expectations start rising, the American central bank will be reluctant to make the same policy error it made during the pandemic, which also featured an energy shock following the Russian invasion of Ukraine.
