US consumer spending falls; tariff-related boost to inflation awaited

U.S. consumer spending unexpectedly declined 0.1% in May, following a 0.2% gain in April, driven by a fading boost from pre-tariff buying and a broader pullback in discretionary spending on goods and services. While the overall PCE Price Index rose a moderate 0.1% monthly and 2.3% year-over-year, the core PCE index increased 0.2% and 2.7% respectively. This data, alongside a 0.4% drop in personal income and a downward revision to Q2 GDP growth estimates, is unlikely to immediately alter the Federal Reserve's 'wait-and-see' approach to interest rates as it continues to assess the full impact of tariffs on inflation, though markets are pricing in rate cuts by September.

Analysis

U.S. consumer spending registered an unexpected 0.1% decline in May, reversing from a 0.2% gain in April and signaling a notable slowdown in economic activity. This retreat was driven by a sharp 0.8% drop in goods spending, particularly a 1.8% decline in durables like motor vehicles, suggesting a payback after consumers front-ran purchases ahead of tariff implementations. More concerning for the economic outlook is the broad-based nature of the weakness, with spending on services increasing by only 0.1%, the smallest gain since November 2020, due to pullbacks in discretionary categories like hotels and restaurants. This slowdown has prompted the Atlanta Fed to revise its Q2 GDP growth estimate down to 2.9% from 3.4%. Concurrently, the inflation picture complicates the Federal Reserve's policy path, as the core Personal Consumption Expenditures (PCE) index, the Fed's preferred gauge, accelerated to 2.7% year-over-year. This combination of slowing growth and persistent, above-target inflation solidifies the central bank's current 'wait-and-see' stance, as the contradictory data points provide no clear signal for an immediate resumption of interest rate cuts.

Key Decisions for Investors

• Given the conflicting signals of slowing consumption and accelerating core inflation, investors should closely monitor upcoming price and labor market data, as these will be critical in determining the timing and magnitude of future Federal Reserve rate adjustments.
• The pronounced weakness in discretionary spending, specifically in autos, hotels, and restaurants, suggests investors should review exposure to the consumer discretionary sector and may consider a more defensive portfolio allocation towards non-discretionary areas like healthcare and utilities.
• Note the divergence between the negative economic data and the positive market reaction in equities, which are pricing in future rate cuts; be cautious of this optimism, as stubbornly high inflation could delay or reduce the scope of Fed easing, creating potential for market volatility.