In August, U.S. consumer spending increased slightly less than expected, but this has done little to shift expectations of solid economic growth during the third quarter. Despite the slower spending pace, other data suggest that the U.S. economy remains resilient, with inflation cooling to its lowest annual rise in over three and a half years. This mix of economic signals is sparking debate over the Federal Reserve’s next steps regarding interest rates.

Consumer Spending: A Vital Economic Indicator

Consumer spending accounts for over two-thirds of U.S. economic activity, making it a critical component of overall growth. In August, spending rose by just 0.2%, slightly below economists’ forecasts of a 0.3% increase, and a dip from July’s 0.5% growth. The slowdown primarily occurred in goods spending, which decreased by 0.1% as purchases of motor vehicles and parts fell. Consumers also spent less at service stations due to falling gas prices, and sales of food and beverages declined as shoppers opted for cheaper store-brand items.

Spending in the services sector, however, remained robust, rising by 0.4% in August, with increases in areas such as housing, utilities, financial services, and insurance. Consumers also spent more on healthcare, transportation, and recreation, as well as at bars, restaurants, hotels, and motels. This resilience in services spending has helped sustain overall economic growth, even as consumers pull back on purchasing durable goods.

Adjusted for inflation, which continues to cool, real consumer spending increased by 0.1% in August, following a 0.4% gain in July. Economists estimate that real consumer spending is currently running at an annualized rate of 3.4% in the third quarter, up from 2.8% in the second quarter. These figures underscore the strength of consumer demand, driven by still-solid wage gains and a higher-than-expected savings rate.

A Cooling Inflationary Environment

One of the most notable developments in August was the moderation in inflation. The personal consumption expenditures (PCE) price index, the Federal Reserve’s preferred inflation gauge, rose by just 0.1%, following a 0.2% increase in July. Over the past 12 months, the PCE price index increased by 2.2%, the smallest year-on-year gain since February 2021. Goods prices actually fell by 0.2%, while the cost of services rose by 0.2%.

Excluding volatile food and energy prices, core inflation also remained muted, rising by 0.1% in August, down from 0.2% in July. On an annual basis, core inflation advanced by 2.7%, up slightly from July’s 2.6% increase. These figures signal that inflation is finally moving closer to the Federal Reserve’s 2% target, which could ease pressure on policymakers to maintain their aggressive stance on interest rate hikes.

The Role of Labor and Wages in Sustaining Growth

Despite the cooling of inflation, the labor market remains a key factor in supporting consumer spending. Wages and salaries increased by 0.5% in August, up from a 0.3% gain in July, providing a cushion for households against rising costs. The strength of wage growth has been an important counterbalance to inflationary pressures, helping sustain consumer demand even as the labor market shows signs of slowing.

Additionally, revised data from the Commerce Department showed that wage and salary growth in the second quarter of 2023 was stronger than previously estimated. This upward revision also applied to the personal savings rate, which stood at a higher-than-expected 4.8% in August, down slightly from July’s upwardly revised 4.9%. Previously reported at just 2.9%, the new data show that consumers are saving more than initially thought, providing a firmer base for future spending.

However, some concerns remain. Rising unemployment, with the jobless rate inching above 4%, could lead to more precautionary saving, which would weaken consumer spending. The upcoming September employment report will be closely watched for further insights into the strength of the labor market and its potential impact on economic growth.

Narrowing Trade Deficit and Rising Inventories

Another factor contributing to the positive outlook for third-quarter growth is the narrowing of the U.S. goods trade deficit. Data from the Commerce Department showed that the goods trade deficit shrank by $8.6 billion, or 8.3%, in August, marking the largest dollar drop since November 2022. The decline was driven by a 1.6% reduction in imports, particularly in industrial supplies and motor vehicles, while goods exports rose by 2.4%, boosted by consumer goods and motor vehicles.

The narrowing trade deficit is expected to impose only a modest drag on gross domestic product (GDP), which could be more than offset by a rise in inventories. Wholesale inventories rose by 0.2% in August, while stocks at retailers increased by 0.5%. These inventory gains are likely to mitigate any negative impact from trade on overall economic growth.

The Atlanta Federal Reserve raised its third-quarter GDP growth estimate to 3.1%, up from an earlier projection of 3.0%. This revision reflects the positive impact of the improved trade data and solid consumer spending. The U.S. economy grew at a 3.0% pace in the second quarter, and these latest figures suggest that growth remained strong in the third quarter.

Federal Reserve’s Next Moves

With inflation moderating and consumer spending remaining resilient, the Federal Reserve faces a complex decision as it prepares for its next policy meeting in early November. The central bank cut its benchmark interest rate by 50 basis points last week, lowering it to a range of 4.75% to 5.00%. This marked the first reduction in borrowing costs since 2020, following a series of aggressive rate hikes that saw the Fed raise its policy rate by 525 basis points over 2022 and 2023.

Financial markets are currently betting on the likelihood of another 50 basis point rate cut at the Fed’s November 6-7 meeting, with odds rising to 52% from 50% earlier in the week, according to CME’s FedWatch tool. The chances of a smaller 25 basis point reduction have dropped slightly to 48%.

Despite the market’s expectations, some economists caution that the Fed may take a more cautious approach. The resilience of consumer spending, the strength of wage growth, and the elevated savings rate suggest that the U.S. economy still has strong foundations, reducing the urgency for further aggressive rate cuts. Michael Pearce, deputy chief U.S. economist at Oxford Economics, said, “The resilience of consumer spending and the stronger foundations strengthen our conviction that the near-term outlook for the economy remains bright.”

However, the upcoming September employment report could provide further clues about the size and timing of future rate reductions. If the labor market shows signs of significant softening, it could prompt the Fed to ease policy more quickly. Conversely, continued strength in hiring could give the central bank room to slow the pace of rate cuts.

While U.S. consumer spending slowed slightly in August, the broader economic picture remains one of resilience and solid growth. With inflation cooling and wage gains supporting consumer demand, the outlook for the third quarter is positive. The narrowing trade deficit and rising inventories further bolster the case for continued economic expansion. However, the Federal Reserve’s next moves on interest rates remain uncertain, with future labor market data likely to play a key role in shaping monetary policy decisions.

(Adapted from MarketWatch.com)

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