July Personal Income & Outlays: Soft Landing?
Consumption growth was strong and underlying inflation rates made progress towards the 2% target.
The July Personal Income and Outlays report provides a good insight on the U.S. consumer as well as inflationary pressures going forward. This note presents some of these insights.
Key takeaways:
Personal income growth out of wages and salaries remained broadly stable in July. Household wage income growth remains in line with the pace that’s broadly consistent with 2% PCE inflation over the medium-term.
The stock of excess savings has NOT run out and continues to be a tailwind for consumption. Between June and July, it fell around $33 billion and equaled about $529 billion in July.
In July headline consumption growth accelerated well above its underlying spending growth. Over the coming months headline spending will likely ease towards the pace of underlying consumption growth. But as the latter improved since early 2024 over a longer horizon and remains above its 2022 and H1 2023 paces, this does not signal that a large downshift in consumption is forthcoming in H2.
Core services excl. housing PCE inflation, the Fed’s favorite gauge of underlying inflation, is now showing a more pronounced slowing momentum. The central tendency measures of PCE inflation are similarly slowing and currently suggests underlying PCE inflation at around 2.4%.
The slowing in underlying inflation measures will no doubt give most Fed officials comfort that policy rates can be cut, and the Fed will start to do this at the forthcoming September FOMC meeting. Given solid underlying consumption growth rates the Fed will likely, for now, pursue a gradual rate cutting path in order to both grind down any remaining stickiness in inflation and to give breathing room for a cooling labor market.
Broadly Stable Wage Income Growth
A dominant source of household income is personal income out of wages and salaries. Today’s report showed essentially no revisions to growth of household income out of wages and salaries for the preceding month (chart below).
The year/year growth rate in July remained essentially unchanged compared to June (chart above), as it decreased to 3.8% from 4% (down from 4.1% initially). Note that overall personal income growth also remained broadly unchanged at around 3.5% year/year.
To interpret wage income growth trends, I earlier proposed to compare wage income growth with a neutral benchmark growth rate based on trend non-farm business sector (NFB) output growth and either the abovementioned common inflation expectations factor or the 2% Fed inflation target. Similar to what I did when discussing wages and inflation expectations in my October 2023 update, I now also incorporate trend labor share growth into this neutral benchmark.
Any deviation in actual household wage income growth above or below the aforementioned inflation target-consistent neutral benchmark means household wage income growth outpaces or cannot sustain in the medium term the 2% inflation target.
The chart above shows that with broadly unchanged wage income growth in July, the wage income growth gap based on the Fed’s inflation target remains essentially closed. Nominal wage income growth thus continues to be broadly consistent with a pace that should be able to bring inflation close to target in the medium term.
Households Still Have Excess Savings
Household spending was up 0.5% over the month in July, whereas disposable household income grew 0.3% for the same period. As a consequence, the savings rate moved down for the sixth consecutive month from 3.1% in May (downwardly revised from 3.4%) to 2.9%.
The chart above shows that the savings rate remains below my trend savings rate estimate of 4.5% (essentially unchanged from a slightly downwardly revised 4.6% in June) using the ‘average of trend’ approach outlined in my earlier excess savings note (orange line). Both remain below trend savings rate assumptions used elsewhere (grey and yellow lines). My trend savings rate estimate does seem to have stabilized now at around 4.5%, as declining inflation uncertainty means households have less of an incentive to dissave.
Given the notably downward revision in trend savings rate estimates earlier in Q2 (May was revised down to 4.8% from 5% initially), in July cumulative excess savings declined from $562 billion in the previous month (revised up from $505 billion) to about $529 billion (see chart above).
Above-trend growth in disposable income continues to be a partial offset to the drawdowns in excess savings coming from above-trend growth in consumption spending and interest payments.
Solid Underlying Consumption Growth
As is the case with headline inflation, headline real consumption spending growth often is driven by volatile components that not always reflect the underlying strength of the economy. A core real consumption spending growth measure, therefore, would be really useful, and I do that by approximating such a core measure based on the weighted median across 177 components1 of headline real personal consumption expenditures (PCE). More specifically, the core, or underlying, consumption growth measure equals the growth rate of the real PCE component at the 50% percentile across growth rates of these 177 sub-components of headline real PCE.
The chart above focuses on three-month annualized consumption growth rates. After accelerating notably during most of 2023, underlying (or core) consumption growth decelerated and stabilized around a 1.5% annualized 3-month rate, higher than the 1% pace observed for 2022. Headline consumption growth overshot the underlying rate by the end of 2023 and the subsequent weakening in real headline spending during Q1 2024 was the consequence of a correction back towards underlying spending growth.
In Q2 2024 headline consumption growth accelerated above underlying spending growth again and this acceleration away from the median consumption growth pace continued in July. This means that we have a really strong starting off point for consumption growth in Q3, but we should also expect the momentum in headline consumption growth to cool as the chart above indicates that headline consumption tends to realign with the median pace when large discrepancies between the two arise.
Nonetheless, over a somewhat longer horizon the underlying (median) consumption growth rate has picked up as well compared to early 2024 (chart above). So even if we would expect headline real PCE growth to cool over the coming months, it likely will not drop off too much. The year six-month rates of underlying spending currently are sitting at a notably higher level than where it was in 2022 or H1 2023.
So, going into Q3 headline consumption remained above trend although spending likely will ease somewhat in the coming months to align with underlying consumption growth that remaining above its 2022 and H1 2023 paces. A large downshift in consumption therefore is unlikely in H2 2024, as households are supported by decent wage income growth rates, still healthy balance sheets as well as unspent accumulated excess pandemic savings.
Underlying Inflation Rates Making Progress Towards 2%
In terms of inflation, core PCE inflation remained broadly unchanged in July at about an 2% annualized monthly rate (June was downwardly revised from 2.2%). Core goods inflation was negative again to +1.4% annualized month/month, down from +1.2% in June, whereas core service inflation accelerated to 3.1% annualized month/month in July from a downwardly revised 2.3% in the preceding month.
The Fed’s favorite gauge of underlying inflation, core services excl. housing PCE inflation, showed a pickup in its pace from (a downwardly revised) 1.9% annualized month/month to about 2.6%. Given the large volatility in this measure since the pandemic it seems worthwhile to smooth through noisy month-over-month dynamics.
The chart above plots three-, six- and 12-month annualized inflation rates for the non-housing core services PCE deflator. The average annualized monthly rate still reads about 4% for the post-COVID era (black dashed line), two times the average rate we observed for the immediate years pre-COVID.
The momentum measures in the chart above have been sticky around 4% for most of 2023. In Q4 2023 momentum in core services excl. housing PCE inflation appeared to ease but this disinflationary trend reversed in Q1 2024. Since April, momentum in this non-housing core services inflation measure slowed again and this slowing became more pronounced over the past couple of months.
Instead of focusing on whether specific components of inflation should be ignored or not when assessing underlying inflation trends, one could focus on the central tendency of consumer price inflation, a.k.a. the center of the distribution of all price changes unaffected by extremely volatile consumer price components. This could potentially provide a better sense of the target toward which inflation moves over time once those excessively volatile price changes have stabilized.
Such measures of central tendency for the PCE price indices use a variety of trimming procedures to weed out excessive volatile components of these price indices in a given month2:
Median CPI, which takes the inflation rate of the component at the 50% percentile of the CPI component price changes.
Trimmed Mean PCE (Dallas Fed), where the highest 31% and lowest 24% of PCE component price changes are dropped.
15% Trimmed Mean PCE, where the highest 7.5% and lowest 7.5% of PCE component price changes are dropped.
20% Trimmed Mean PCE, where the highest 10% and lowest 10% of PCE component price changes are dropped.
30% Trimmed Mean PCE, where the highest 15% and lowest 15% of PCE component price changes are dropped.
The chart above scales each of these measures into a three-month average distance relative to 2% core PCE inflation as a measure of the Fed's inflation target. In Q1 2024 all underlying three-month average inflation rates sharply overshoot the Fed's inflation target. But since April this overshoot eased notably with the three-month average deviations dropping towards the inflation target. Three-month average deviations of underlying inflation rates relative to target now are close to zero or negative, similar to what we have seen at the end of 2023.
Alternatively, it might be more insightful to look at the smoother six-month averages of the annualized percentage point deviation of monthly central tendency inflation measures relative to their values as implied by 2% core PCE inflation. This is also consistent with public statements by Fed officials that they’d like to see sustained progress of inflation converging back to target. For example, the newly minted St. Louis Fed President Alberto Musalem suggested at some point it "[...] could take months, and more likely quarters [...]" of inflation progress before he'd be comfortable with policy easing. My interpretation of these statements is that Fed officials would be more inclined to start cutting the Fed funds rate if the annualized six-month average reading across underlying core PCE inflation rates would hit 2.5% or less, as most of these measures were at or below this threshold around the time of the December 2023 FOMC meeting.
The chart above suggests a qualitatively similar story as for the three-month average measures: a lot of progress was made by the end 2023 in terms of a return back towards the Fed’s 2% inflation target, in early 2024 this progress stalled but then returned later on.
The six-month average deviations of underlying PCE inflation rates relative to the inflation target in the chart above have declined notably over the last couple of months and are now suggesting an underlying PCE inflation trend of around 2.4%. As such the different central tendency inflation measures are signaling progress in terms of an eventual return of core PCE inflation towards the Fed’s inflation target.
From the perspective of the Fed underlying inflation rates have now shown enough progress that for Fed officials to be comfortable with commencing rate cuts at the upcoming September FOMC meeting. Given still strong underlying spending growth the Fed can, for now, afford to pursue a gradual policy rate easing path aimed at dialing down the restrictiveness of its policy stance. Such an approach would allow the Fed to grind down any remaining stickiness in inflation (or pre-empt an inflation pickup) while decreased restrictiveness, in combination with continued solid household spending, can give the labor market breathing space that would avoid labor market cooling morphing into an outright deterioration.
For a description of these 177 components, see Appendix A in the Dallas Fed trimmed mean PCE inflation working paper, where I use the corresponding real quantities instead of the price indices.
The trimming is based on the inflation rates of 177 components of the PCE deflator, see Appendix A in the Dallas Fed trimmed mean PCE inflation working paper,