The US economy is entering a more complicated phase as inflation remains well above the Federal Reserve’s target while consumers show signs of becoming more cautious. July data presented policymakers with an uncomfortable combination: prices continued rising at a stubborn pace, while inflation-adjusted consumer spending failed to increase.
The figures complicate the outlook for interest rates and raise concerns about whether the world’s largest economy can maintain strong growth without reigniting inflation.
Inflation Remains Too High
The Personal Consumption Expenditures price index, the Federal Reserve’s preferred inflation measure, rose 0.2% in July from the previous month and remained at 3.7% annually. Core PCE inflation, which excludes food and energy, also increased 0.2% monthly and held at 3.3% year over year.
Both measures remain significantly above the Fed’s 2% target.
That matters because inflation has not shown enough consistent progress for policymakers to declare victory. The problem is particularly sensitive for the Fed because services and other persistent price pressures can take longer to disappear than temporary increases in goods prices.
Consumers Hit the Brakes
At the same time, inflation-adjusted consumer spending was flat in July after increasing 0.4% in June. Nominal spending rose only 0.2%, its weakest monthly increase in several months.
That does not mean Americans stopped spending altogether.
Rather, the data suggest consumers are becoming more selective.
Households continued spending on necessities and services, but purchases of goods weakened. The result is an economy where headline spending can still look reasonably healthy while the underlying volume of consumption is losing momentum.
The Stagflation Question
The combination of persistent inflation and weaker real spending inevitably raises concerns about stagflation.
That term should not be used too casually. The US economy is not currently experiencing a classic stagflationary recession, and incomes remain relatively resilient.
But the direction is uncomfortable.
If inflation remains elevated while real consumer demand weakens, the Fed faces a difficult policy problem. Cutting interest rates could support demand but risk keeping inflation high. Keeping rates elevated could help suppress prices but further weaken households and businesses.
The Fed Has Less Room for Error
Federal Reserve Chair Kevin Warsh reinforced the inflation concern during his speech at Jackson Hole.
Warsh said the central bank must be confident that underlying inflation is moving toward the 2% objective clearly and quickly. Markets interpreted the remarks as a warning that another rate increase could be possible at the September meeting.
That is a significant shift in market expectations.
Investors had increasingly hoped that slowing activity would allow the Fed to reduce borrowing costs. Persistent inflation makes that assumption less secure.
September Rate Decision Matters
The next Federal Reserve meeting will therefore attract unusually close attention.
Markets have increased the probability assigned to a September rate hike following Warsh’s Jackson Hole remarks. The precise decision will depend heavily on incoming employment and inflation data.
A rate increase would make borrowing more expensive for households and businesses.
Mortgage rates, corporate financing costs and consumer credit could all remain under pressure.
But if inflation refuses to fall, the Fed may conclude that accepting weaker demand is preferable to allowing price pressures to become entrenched.
Income Growth Offers Some Protection
There is at least one positive element in the data.
Household incomes continued to rise. Disposable income increased during July, helping consumers maintain spending despite higher prices. The personal saving rate also increased to around 3% from 2.6% in June.
That suggests consumers are not necessarily running out of money.
Instead, some households may be rebuilding savings after earlier periods of heavy spending.
This distinction matters because a higher saving rate can provide households with a financial cushion if economic conditions weaken further.
Lower-Income Households Face More Pressure
The aggregate numbers also conceal significant differences between households.
Higher-income Americans have benefited from strong equity markets, relatively stable employment and greater financial reserves.
Lower- and middle-income households are more exposed to everyday costs such as food, housing, healthcare and transportation.
Recent reporting has pointed to weaker retail performance and greater financial pressure among some lower-income consumers, suggesting that the slowdown is not evenly distributed across the economy.
That creates a potentially important vulnerability.
If financially weaker households begin cutting spending more aggressively, the slowdown could spread into a wider range of businesses.
Services Remain Important
The US economy is increasingly driven by services, which makes the inflation picture more complicated.
Consumers continue spending on healthcare, food, hotels, transportation and other services even as purchases of physical goods weaken.
Services inflation can be particularly difficult for central banks because it is often linked to wages, rents and domestic demand.
If service prices remain elevated, the Fed may find it difficult to reduce interest rates even if goods inflation becomes more manageable.
Global Markets Are Watching
The US economy matters far beyond American consumers.
Federal Reserve policy affects global borrowing costs, currency markets, bond yields and capital flows.
A more hawkish Fed can strengthen the dollar and put pressure on emerging-market currencies and economies that borrow in dollars.
Higher US yields can also make American assets more attractive relative to overseas investments.
That means the latest inflation and spending figures are being watched closely by policymakers and investors around the world.
The Dollar Could Gain Support
A higher-for-longer interest-rate outlook generally provides support for the US dollar.
If investors believe the Fed will maintain restrictive policy while other central banks cut rates, the yield advantage of dollar assets can increase.
But currency markets also depend on expectations for economic growth and fiscal policy.
If US growth slows sharply, the dollar’s support from higher interest rates could eventually be offset by concerns about the economy.
Other Central Banks Face Similar Problems
The inflation problem is not exclusively American.
European policymakers are also watching persistent price pressures, while several central banks are balancing inflation risks against weaker economic activity.
That makes the global policy environment unusually uncertain.
If the Fed keeps rates high while other central banks ease, global capital flows could shift toward the US.
If inflation eventually falls more quickly, however, expectations could reverse just as rapidly.
Businesses Are Caught in the Middle
Companies face their own version of the dilemma.
Higher input costs make it difficult to maintain margins, but consumers are becoming less willing to accept large price increases.
Businesses therefore have to decide whether to absorb higher costs, reduce expenses or pass the increases to customers.
Companies with strong brands and pricing power are better positioned.
Smaller businesses with thin margins may have much less flexibility.
The Bigger Economic Question
The central question is whether July represents a temporary slowdown or the beginning of a more sustained cooling in consumer demand.
One month of flat real spending is not enough to establish a trend.
The US economy entered the summer with considerable momentum, and revised data indicate that private-sector demand remained relatively strong.
But if spending remains weak through August and September, economists may begin reassessing the growth outlook.
Conclusion
The latest US economic data present policymakers with an awkward combination of persistent inflation and weaker consumer momentum.
Headline PCE inflation remained at 3.7% in July, while core inflation stayed at 3.3%, both well above the Federal Reserve’s 2% target. At the same time, inflation-adjusted consumer spending was flat after stronger growth in June.
The danger is not that the US economy has suddenly entered recession.
The more immediate concern is that inflation is proving difficult to eliminate just as consumers begin showing signs of caution.
That leaves the Federal Reserve with a difficult choice.
If policymakers cut rates too soon, they could stimulate demand and make inflation harder to control. If they keep monetary policy restrictive for too long, they risk turning a modest slowdown into a more serious economic contraction.
Kevin Warsh’s Jackson Hole speech suggests inflation remains the Fed’s primary concern. Markets responded by increasing expectations for a possible September rate hike.
For consumers, the key issue will be whether incomes continue to rise faster than prices. For businesses, it will be whether customers remain willing to absorb higher costs. For investors, the critical variable is how quickly inflation moves back toward the Fed’s target.
The US economy is therefore not facing a simple “inflation versus growth” problem.
It is facing the harder scenario in which inflation remains too high while growth begins losing momentum.
That is precisely the environment in which monetary policy becomes most difficult—and why the next few months of inflation, employment and spending data could determine the direction of global markets.
