The Federal Reserve may be expecting inflation to pick up, yet it was clear in the Personal Income and Spending Report for May that the Federal Reserve has been left wanting. What that report revealed was disinflation, not inflation.
The report also revealed some other important economic information. It showed a rising personal savings rate, stagnant growth in real personal consumption expenditures, and weak growth in real disposable personal income.
The sum of those parts should stack up to more of the same for real GDP growth, which is to say it won't be entirely weak but it won't be entirely strong either.
The Federal Reserve's longer-run inflation target is 2.0% and it is based on the PCE Price Index. Earlier this year, that price index exceeded the longer-run target, yet that proved to be an ephemeral position thanks to the sharp drop in energy prices.
The current trend of disinflation, though, isn't just a product of falling energy prices. The core PCE Price Index, which excludes food and energy, has also faded since February.
The Federal Reserve is inclined to think that is mostly the result of some temporary factors, like lower prices for wireless services, but the trend has yet to reverse as lower year-over-year readings for the core PCE Price Index have been seen for three consecutive months.
In May, the PCE Price Index was up 1.4% year-over-year, versus 1.7% in April, while the core PCE Price Index was up 1.4% compared to 1.5% in April.
That is not the stuff Fed rate hikes are made of -- at least not in the market's mind. Our assumption is that the same holds true in the Fed's mind, too, yet leading officials there haven't been heard backtracking yet on their assumption that the tight labor market will produce stronger wage inflation that leads to broader price inflation.
Minneapolis Fed President Kashkari (an FOMC voter) didn't vote in favor of the rate hike at the June meeting and has been left wondering why there seems to be a rush to raise rates. Philadelphia Fed President Harker (an FOMC voter) thinks another rate hike this year is likely, but has conceded that he would have to revisit that view if inflation moves away from the Fed's goal. St. Louis Fed President Bullard (a non-FOMC voter) is on record saying he thinks the FOMC has been too hawkish relative to the incoming data over the last 90 days or so.
In short, there is some dissension -- and some possible dissension -- in the ranks insomuch as it relates to the policy rate path, but until a leading member like Fed Chair Yellen, Vice Chair Fischer, and/or New York Fed President Dudley pay some more concerted lip service to the inflation readings, the market isn't going to rest easy.
It will have some rate-hike angst, or, more specifically, some angst that the Fed stands to make a policy mistake by raising the target range for the fed funds rate too much, too soon, and choking off economic recovery efforts.
An Income Problem That's a Spending Problem
The aforementioned recovery efforts aren't exactly robust to begin with either. First quarter real GDP increased 1.4% at a seasonally adjusted annual rate. The Atlanta Fed's GDPNow model forecast for second quarter real GDP growth is 2.7%, down from the starting forecast of 4.3% seen on May 1.
The U.S. economy, therefore, looks slated to grow at an average rate of about 2.0% for the first half of 2017. It will do so with the Federal Reserve having raised the fed funds rate four times since December 2015.
Since 2.0% is close to the average annual growth rate of 2.1% since 2010, it is fair to say the U.S. economy has taken the rate hikes in stride to this point. The flattening yield curve, however, connotes some concern that the higher policy rates, and the specter of more to come, are going to create some consumption problems down the road.
The Personal Income and Spending Report for May wasn't a problem-free report in that respect either.
Real PCE increased just 0.1% month-over-month and left the year-over-year growth rate for real PCE unchanged at 2.7%. That meek spending growth, incidentally, coincided with a jump in the personal savings rate to 5.5% from 5.1% in April, and a modest pickup in the pace of real disposable income growth to 2.2% year-over-year from 1.9% in April.
The latter was nice to see, yet it's a lower pace of year-over-year growth than what was seen in May 2016 (2.8%) and May 2015 (3.6%).
A lot of people like to make a big deal out of the elevated consumer confidence readings being a good sign for consumer spending. They don't hurt, but the economic fact of the matter is that income growth matters far more for spending activity than consumer confidence does.
If disposable income growth is lagging, spending growth will be too.
What It All Means
The CME FedWatch Tool indicates the market isn't expecting a rate hike at either the July, September, or November FOMC meetings. It places a 55.4% probability on a rate hike at the December meeting, which is to say it has some otherwise mixed feelings about a rate hike happening at that meeting.
That sentiment will shift one way or the other with subsequent inflation reports. The one the market got in the Personal Income and Spending Report for May was not on the Fed's rate-hike side, so it stands to reason that the FOMC will take a pass on another rate hike at the July 25-26 meeting.
The market isn't expecting a rate hike at the September 19-20 FOMC meeting, but key Fed officials haven't worked yet to adequately confirm the market's suspicions. They'll likely wait on the June CPI report on July 14 before embarking on any type of communication campaign to walk back, or to advance, their inflation expectations.
The PCE Price Index that was part of the Personal Income and Spending Report for May was a step back for the Fed's inflation view; meanwhile, the report overall was a step in place for an economy that has been walking a long path of low growth and low inflation.