The Federal Reserve’s preferred inflation indicator increased 2.6 per cent in July—2.596 per cent versus 2.565 in June—implying an increasingly difficult policy decision on whether to cut interest rates at its Sept. 17 meeting.
The August reading of inflation advanced 0.2 percent on the month in the topline index and 0.3 percent in the core. This translated to 2.6 percent and 2.9 percent respective increases from a year ago.
Personal spending increased 0.4 percent as households took advantage of online sales, while three extra working days in July bolstered income growth by 0.5 percent on the month—both of which are quite strong.
Upon examining the data, there was a solid increase in outlays on autos—but spending was weak elsewhere. Tariff-induced price increases across the durables sector likely curbed the appetite of household to bolster spending on those items.
Policy implications
While it appears the Fed is heading towards a 25 basis-point rate cut in September—which is our current policy forecast—the latest data tends to suggest this is a risky step with respect to rising inflation.
We ran four different models to estimate the optimal policy rate. Using the updated personal consumption expenditures (PCE) and core PCE inflation data yields the following results:
Utilizing the Fed’s PCE policy variable at 2.6 percent, setting the long run real neutral rate at 1.35 using the Laubach-Williams two-sided test and setting the non-accelerating rate of inflation and unemployment to 4.2 percent, it yields an optimal policy rate of 4.25 percent. This implies holding on rates would be the more prudent policy choice at this time.
If one uses core PCE and utilizes the same estimates for the long-run real neutral rate and the non-accelerating inflation rate of unemployment (NAIRU), it yields a 4.67% optimal rate. Conducting the same estimate using CPI and core CPI results in optimal policy rates of 4.4 percent and 5 percent.
Our four models imply policy choices that range from a hold to a rate hike given the current range of economic and financial data.
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This all strongly suggests that the upcoming estimate of the August U.S. jobs report—in addition to the August consumer price index, producer price index and PCE inflation—will prove decisive on whether the Fed cuts rates in September.
We currently expect an increase of 80,000 jobs in August along with a 4.3 percent increase in the unemployment rate.
If the August jobs report arrives at 50,000 or below, one might conclude that the Fed will cut rates. If it arrives above 100,000, that outcome will likely prove difficult.
If it lands in between, it’s essentially a coin flip and the decision will be based on a judgement call of whether Fed inflation expectations are sufficiently entrenched to look through sticky, stubborn and rising inflation.
The data
Compensation, wages and salaries advanced 0.6 percent in July as disposable income increased 0.5 percent and the savings rate remained unchanged at 4.4 percent.
This all supported a 3.1 percent increase in personal spending on a three-month annualized pace, which slowed from 3.6 percent previously.
Unfortunately, that is all nominal because upon adjusting for inflation, it looks much weaker.
On an inflation-adjusted basis, personal spending increased 1 percent on a three-month average annualized basis—down from 1.6 percent previously. Meanwhile, personal income excluding government transfers increased 0.3 percent and inflation-adjusted disposable income increased 0.2 percent.
Topline inflation increased 2.1 percent on a three-month annualized basis and is up 2.9 percent over the past six months. Using that same metric, core inflation increased 2.5 percent over the past six months and is up 3.1 percent over the past six months.
When digging into the details of the latest PCE data, one can observe the effects of tariffs showing up in the hard data in July.
The takeaway
While nominal gains in spending and income look strong on the topline, adjusting for inflation is necessary—and subsequently implies an economy that is growing just above 1 percent.
Rising core inflation, stubborn topline inflation and the details of the report—which show tariff-related pricing pressures and sticky service-sector inflation—all point towards a difficult September policy decision.
We expect the Fed to cut rates by 25 basis points. However, the range of models we ran to estimate the optimal policy rate strongly suggests that holding off on cutting rates would be the more prudent move at this point.
