US Inflation Stalls as Goods Prices Drop; Spending Rises

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Monthly inflation in the US was flat in May, as a modest rise in service costs was balanced by the largest drop in goods prices in six months. This development brings the Federal Reserve closer to potentially cutting interest rates later this year. The Commerce Department’s report also indicated a slight increase in consumer spending last month, suggesting a possible “soft landing” for the economy where inflation decreases without triggering a recession or a significant rise in unemployment. Following the report, traders increased their bets for a rate cut by the Fed in September.

James Knightley, chief international economist at ING, commented, “It helps the argument that inflation is looking better-behaved, which may well open the door to interest rate cuts later in the year.”

The personal consumption expenditures (PCE) price index remained flat last month, following an unrevised 0.3% increase in April, according to the Commerce Department’s Bureau of Economic Analysis. Goods prices fell by 0.4%, the most significant drop since November, with notable declines in the prices of recreational goods, vehicles, furnishings, and durable household equipment. Additionally, gasoline and other energy goods prices dropped by 3.4%, and clothing and footwear also became cheaper.

Service costs rose by 0.2%, driven by higher prices for housing, utilities, and healthcare, although financial services and insurance costs declined by 0.3% after rising for five consecutive months. These costs, along with housing, have been major drivers of service inflation.

On a year-on-year basis, the PCE price index increased by 2.6% in May, down from 2.7% in April, aligning with economists’ expectations. Inflation is cooling after a spike in the first quarter, with the Fed’s 525 basis points worth of rate hikes since 2022 tempering domestic demand. However, inflation remains above the Fed’s 2% target.

Financial markets now see a roughly 68% chance of a September rate cut, up from about 64% before the data, despite the Fed’s recently more hawkish stance. The Fed has kept its benchmark overnight interest rate within the 5.25%-5.50% range since last July.

US stocks opened higher, the dollar remained largely unchanged against a basket of currencies, and US Treasury prices were mostly higher.

Spending Rises Moderately

Excluding volatile food and energy components, the core PCE price index edged up by 0.1% last month, the smallest gain since November, following an upwardly revised 0.3% increase in April. Previously, the core PCE price index was reported to have risen by 0.2% in April. Core inflation increased by 2.6% year-on-year in May, the smallest advance since March 2021, after rising by 2.8% in April.

The Fed monitors the PCE price measures for monetary policy. Monthly inflation readings of 0.2% over time are necessary to bring inflation back to target. PCE services inflation, excluding energy and housing, also ticked up by 0.1% last month after advancing by 0.3% in April. This “super core” inflation reading is being closely watched by policymakers to assess progress in lowering price pressures.

Consumer spending, which accounts for over two-thirds of US economic activity, increased by 0.2% last month after rising by 0.1% in April, according to the report. Inflation fatigue, higher borrowing costs, and dwindling savings are holding back spending. Nonetheless, consumer spending is supported by a resilient labor market, which continues to generate strong wage gains. Personal income increased by 0.5% after climbing by 0.3% in April, with wages rising by 0.7%.

Inflation-adjusted disposable income rose by a solid 0.5%. Consumers saved more, lifting the saving rate to 3.9% from 3.7% in April. Inflation-adjusted consumer spending rebounded by 0.3% after slipping by 0.1% in April. This rise in “real” consumer spending bodes well for growth in consumption this quarter.

Consumer spending slowed sharply in the first quarter, helping to restrict the economy to a 1.4% annualized growth rate. The economy grew at a 3.4% pace in the fourth quarter. Growth estimates for the second quarter are mostly below a 2% rate.