Savings and slower inflation support spending

Inflation is slowing unevenly. 

“We still think a December rate cut is possible.” 

Disposable personal incomes rose only 0.1% for the fourth consecutive month after adjusting for inflation. Consumer spending surged an inflation-adjusted 0.4% while the savings rate fell to 4.6%. The gains in spending were stronger for goods than services, including big-ticket items which often require financing. We saw that in the quarterly data released yesterday. 

The drawdown in savings is not as dramatic in light of post-benchmark revisions, released in September. Incomes were revised up over the last year, which means consumers entered the new school year with more resources.  

Older, wealthier households have begun to tap the equity in their homes using home equity lines of credit. This is enabling them to continue a pre-pandemic trend of making repairs and upgrades to existing properties when mortgages are very low or paid off. The result is fewer listings for millennials, who have been locked out of the existing home market.  

Slowing inflation  

The personal consumption expenditure (PCE) index, which the Federal Reserve targets, rose 0.2% in September, a slight uptick from the 0.1% pace of August. However, year-over-year measures of the PCE dropped to 2.1% after rounding, the coolest pace since February 2021 and about as close to the Federal Reserve’s 2% target as we have seen in recent years.  

The core PCE, which strips out food and energy, came in at 0.3% in September, up slightly from the 0.2% of August. That translates to 2.7% on a year-over-year basis, the same as August. However, the data slipped to 2.65% before rounding, which is small but still in the right direction for the Fed.  

The super core services PCE rose 0.3% in September after rising 0.2% in August. That translates to 3.2% year-over-year, down from 3.4% in August and puts us back where we were in July. The largest sticking point on a year-over-year basis is insurance costs, which are rising in response to larger claims and increased payouts due to litigation. The good news is that insurance premiums cooled a bit on a month-to-month basis. The recent hurricanes affect insurance costs with a lag and will not likely add to the upward pressure on insurance costs until well into 2025 and 2026.  

On a monthly basis, airfares jumped an outsized 2.7%, the largest increase since April 2022; airfares had been declining in recent months. Higher education services jumped 0.9%, the largest monthly increase in 13 years. That marks a reversal of cooling inflation in tuition costs and was larger than usual for the start of the school year. Next in line, were healthcare costs, which are a major driver of service sector inflation.  The healthcare component alone was up 0.4% in September, the largest gain since January.  

Childcare costs, in a different category than healthcare costs in the PCE, rose 0.4% after two outsized increases in July and August. The care crisis remains a major problem for working families. Our own Parental Work Disruption Index shows the hours lost to childcare have risen considerably since the pandemic.  

Eldercare is affecting many of the same families, as older millennial parents are taking care of both their children and parents. Costs for homes for seniors surged 2.1% during the month, the second largest monthly increase since the start of series in 1987. 

The silver lining for the Fed is that the dispersion of outsized increases in prices has narrowed considerably over the last year. The most stubborn inflation components are those noted above. The upward pressure in service sector costs is being tempered by actual declines in goods prices.  

More good news for inflation 

Separately, the employment cost index, which includes productivity growth, slowed to a 3.9% increase over the summer compared to a year ago; it’s 0.2% below the 4.1% annual gain we saw in the second quarter and the slowest pace in three years.  

Productivity growth has picked up post-pandemic. That is good news in that it limits the pass-through of higher costs to consumers. The last time we saw a big move up in productivity growth was in the late 1990s.  That enabled the Fed to experiment with how low unemployment could go without triggering inflation. It also left us with a higher noninflationary fed funds rate.  

That is consistent with the Fed’s own estimates of the neutral or noninflationary fed funds rate, which has moved up post-pandemic. The Fed is reviewing its monetary policy framework in 2025. The debate over how low the fed funds rate can go without stoking inflation will heat up as we move into 2025. We do not expect the Fed to return to the ultralow rate environment we saw pre-pandemic, barring a recession.  

Bottom Line 

Today’s data confirm the remarkable resilience of consumers and their ability to push back on price hikes. Service sector inflation remains the stickiest and requires a more rapid cooling of goods prices to keep overall inflation down. A rate cut at the Fed’s November meeting is all but a done deal; we still think a December rate cut is possible. Some on the Fed will debate skipping a meeting due to the remarkable strength of the economy. Noisy data due to hurricanes and strikes and hesitation in investment due to a close election are expected to dampen growth in the fourth quarter.