Very Strong Services Inflation Is a Problem for Fed

• Personal income increased 0.4% in November, while consumer spending rose 0.1%.
• Higher interest rates are weighing on goods spending.
• Inflation was modest, with prices up 0.1% over the month, and core prices up 0.2%. Year-over-year inflation also slowed but remains much higher than the Fed would like. Services inflation remains especially high.
• Household income rose modestly in November after adjusting for inflation, while spending was flat.
• The Fed will continue to raise interest rates into early 2023, and PNC expects a mild recession next year.

Personal income increased 0.4% in November from October, according to the Bureau of Economic Analysis. After-tax income was also up 0.4%. Wages and salaries rose 0.5% over the month, as did investment income. Self-employment income fell slightly in November.

Consumer spending increased 0.1% before adjusting for prices in November. There was a big 2.3% drop in spending on durable goods as higher interest rates and continued problems with auto supply were drags. Nominal spending on nondurable goods fell 0.2%, in part due to lower energy prices, while services spending rose 0.7%. Consumers are reorienting their spending to services after a surge in goods spending and a huge drop in services spending, during the initial recovery from the pandemic. Higher interest rates are also weighing on goods purchases.

With income up more than spending, the personal saving rate rose to 2.4% in November from 2.2% in October, but it remains near a record low.

The personal consumption expenditures price index rose a scant 0.1% in November, with the core PCE price index (excluding volatile food and energy prices) up 0.2%. Durable goods prices fell 0.8% as demand fell with higher interest rates. Food price rose 0.3% over the month, the smallest increase since December 2021. But services inflation, which tends to be sticky, increased a solid 0.4% in November.

On a year-over-year basis overall PCE inflation was 5.5% in inflation, down from 6.1% in October and a peak of 7.0% in June. Core PCE inflation was 4.7% in November, down from 5.0% in October and a recent peak of 5.4% in February. But core and inflation both still remain far above the Federal Reserve’s 2% objective.

After adjusting for inflation after-tax household income growth was 0.3% in November, while consumer spending was flat.

The economy is moving in the right direction from the Federal Reserve’s perspective at the end of 2022, but not quickly enough. Higher interest rates are weighing on consumer spending, particularly for durable goods, and inflation is slowing. But services inflation came in at 0.4% for the month and is running at more than 11% on a year-over-year basis. Much of this services inflation is due to housing costs, which are rapidly reversing.

But the Fed is concerned that strong wage growth will lead to persistent increases in services prices and high overall inflation. The Federal Open Market Committee will continue to increase the fed funds rate in early 2023 until it becomes more apparent that the job market is cooling, and wage growth and services inflation are slowing to more sustainable paces.

PNC expects the FOMC to raise the fed funds rate by 25 basis points at its next two meetings, in early February and mid-March, to a range of 4.75% to 5.00%. This is up from essentially zero at the beginning of 2022. The U.S. economy is set to fall into recession in the spring of 2023 given the rapid increase in both short-term and long-term interest rates over the last year or so. But the recession should be mild as businesses try to limit layoffs, consumers have a savings cushion, the financial system is in good shape, and the housing market remains undersupplied. Household income growth will slow with recession. Consumer spending will decline modestly next year, concentrated in durable goods, which are very interest-rate sensitive.

Inflation should slow in early 2023 as lower prices for goods and housing work their way through the system, and then in late 2023 and early 2024 as a softer labor market constrains wage growth. PNC expects inflation to return to the Fed’s 2% objective by late 2023 or early 2024.