Fed's Inflation Battle Intensifies as PCE Drops Slightly, Consumer Spending Slumps

The Federal Reserve's job of managing the economy and controlling inflation has not become easier, despite a slight dip in the central bank's preferred inflation gauge in January. The Personal Consumption Expenditures (PCE) index, which rose 2.5% annually, was down from 2.6% in December, but still far from the Fed's 2% target. Core PCE, excluding volatile food and energy costs, also saw a decline to 2.6% from 2.9% in December.

Adding to the complexity of the Fed's mandate, consumer spending decreased by 0.2% in January, led by a drop in spending on motor vehicles, household furnishings, and recreational goods. This decline, coupled with sharp income growth, has thrown a wrench into expectations for a quarter of economic expansion. Personal income increased by 0.9% month over month, driven by private wages and salaries and sharp increases in personal current transfer receipts, largely due to beginning-of-year Social Security payment adjustments.

The latest data has significantly lowered expectations for the first quarter's GDP outlook. The Atlanta Fed's GDPNow model has been revised to project a contraction of 1.5% during the first three months of 2025, which would be the first contraction recorded since Q1 2022. This revision comes after the model had previously called for expansion at a rate of 2.3% during the first quarter of this year.

In terms of market impact, stocks initially rose slightly on the mild decline in headline PCE but quickly erased any gains as geopolitical tensions took center stage. The Fed funds futures markets are still calling for central bankers to hold interest rates at their next meeting on March 19, with a 94% probability of this outcome.

While the slight dip in headline inflation is encouraging, it is unlikely to satisfy Fed Chair Jerome Powell, given the current labor market situation. The Fed will have to wait and see how Powell is thinking about the long-term outlook, as the central bank continues to grapple with the challenges of managing inflation and economic growth.