We have spent much of the last two months (including in a recent piece here) defending our increasingly out-of-consensus call for three Fed rate cuts in 2025. A series of recent data disappointments has brought market pricing much closer to that view. This, of course, does not prove the point, but underscores what had been the core message all along: there are two-sided risks to our US soft landing forecast.
There had already been some worrying signs the week before: another drop in consumer sentiment and rise in inflation expectations in the University of Michigan survey, plus the first sub-50 reading in over two years for the S&P Global services PMI. This week, the theme of disappointments continued with a sharp retreat in the February Conference Board consumer confidence index and culminated with the outright decline in January consumer spending.
Within days, we seem to have swung from proclamations of apparent invincibility to worried questioning of whether the economy is somehow broken. Neither is true. We can’t help but be reminded of a similar situation in 2024, when the release of a softer-than-anticipated first-quarter GDP report also shifted macro assessments from “boom” to “stagflation” seemingly overnight.
It would be unwise to panic, just as it was unwise to look at the exceedingly strong growth in fourth-quarter consumer spending and assume it could be sustained. As we wrote at the time, the economy exhibited “a lot of peculiar dynamics that look likely to reverse in the coming quarter”. We are now in the midst of one of those reversals. For instance, we noted then in regard to motor-vehicle sales, that “having approached 17.0 million (annualized) in December, the scope for further material gains here seems limited”. Indeed, January brought a sharp pullback (15.6 million saar), which was one of the big drivers behind the 0.2% m/m decline in nominal consumer spending. Real personal spending plunged 0.5% m/m, which was the first monthly decline since January 2024. However, despite the sequential retreat, real personal consumption was 3.0% higher y/y, a solid print.
The January PCE (personal consumption expenditure) deflator data was largely as expected and provided what under normal circumstances (i.e., no impending tariffs) would likely be deemed by the FOMC as evidence that progress on the inflation front is resuming. The headline PCE deflator increased 0.2% m/m and the core PCE deflator rose 0.3%, lowering the two respective inflation measures by one and three tenths, respectively, to 2.5% y/y and 2.6% y/y.
This was the first improvement in the y/y core PCE inflation rate since June. There should be a little further progress near-term and then a plateau around 2.5% y/y for much of the second half. The retreat in January PCE inflation, plus likely signs of labor market erosion, support a June Fed cut. The federal employees who have accepted the DOGE buyout offer (roughly 75,000) will likely not show up in the data until November (i.e., the October payrolls) but enough is happening outside of that already between outright terminations and hiring delays at state level or even in the private sector amid uncertainty over funding and procurement. Hence, the labor market should loosen.
