For more than a year now, the U.S. economy has faced two fundamental, interwoven challenges: Consumers wouldn’t stop spending, and prices wouldn’t stop rising.
Both trends are now showing early signs of reversing.
Consumer spending fell in both November and December, the Commerce Department said on Friday, as shoppers pulled back amid rising prices, dwindling savings and warnings of a looming recession.
Inflation is also easing: Consumer prices rose 5 percent in the year through December, according to the Federal Reserve’s preferred measure. While still much more rapid than normal, that was the slowest pace in more than a year.
Taken together, the figures paint a picture of an economy that is, at long last, coming off the boil. From the Fed’s perspective, that is good news: The central bank has spent the past year aggressively raising interest rates in an effort to force consumers and businesses alike to pull back their spending, which should result in slower price increases. Now there is mounting evidence those efforts are bearing fruit.
“The medicine is taking,” said Sarah Watt House, senior economist at Wells Fargo. “The economy is on the right path.”
That path is an uncertain and narrow one, however. So far, the Fed has managed to cool down the economy without short-circuiting the recovery and causing a big increase in unemployment. But the full effects of its actions have yet to be felt.
Policymakers are expected to raise rates by another quarter point at their meeting next week, a move that would put rates in a range of 4.5 to 4.75 percent. Even once they stop raising rates, the central bank has indicated it expects to keep borrowing costs high for a significant period.
Many forecasters doubt the Fed will be able to bring down inflation as far as it wants without causing a recession, which some expect to begin later this year.
There are also risks in the other direction: The recent slowdown in inflation and spending, while encouraging, could still reverse. The labor market remains very strong, for instance, which could continue to fuel the economy.
“You’re starting to see the early signs of what the Fed needs to see,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank Securities. “It’s still early, and you don’t know how much of this will be persistent.”
The data released Friday showed that consumer prices rose 0.1 percent in December for the second straight month, and were up 5 percent from a year earlier, a notable annual slowdown from 5.5 percent in November and a continuation of a six-month downward trend. The measure, the Personal Consumption Expenditures price index, is related to the better-known Consumer Price Index and is the Fed’s preferred measure of inflation.
After food and fuel are stripped out, the price index climbed 4.4 percent from a year earlier, in line with what economists in a Bloomberg survey had expected and a slowdown from 4.7 percent in November.
Consumer spending fell 0.2 percent in December, and spending for November, which the government initially reported as a modest increase, was revised to show a small decline.
Incomes continued to rise, reflecting the strong job market. But instead of spending their extra income, Americans chose to save more, a sign that people may be becoming more cautious amid news of layoffs and talk of a possible recession. Households, in the aggregate, still have hundreds of billions of dollars in savings built up during the pandemic, but that cushion has been shrinking.
“Overall, it’s a sign that consumers are becoming more cautious,” Ms. House said. “Consumers are beginning to retrench.”
The data is consistent with anecdotes suggesting that consumers, after months of spending freely, are becoming more sensitive to rising prices.
At the clothing chain Express, for instance, people shopping for women’s apparel have become more attuned to cost again. The company is responding to that, Timothy Baxter, the company’s chief executive, said on an earnings call in December.
“We are recalibrating our assortments to reintroduce more opening price points, more price points that are more in line with where we have been historically,” Mr. Baxter said.
But he noted that the return in price sensitivity wasn’t true across the board — for instance, demand for jackets with modern tailoring has been strong.
“We’ve seen very little price resistance actually there because the value we offer in those categories is so extraordinary,” he said.
Friday’s data are among the last readings on the state of the economy that the Fed will receive before it announces its interest rate decision next week.
Central bankers are particularly watching the labor market and spending trends as they try to guess how many more policy adjustments are needed — and how long rates should be held at a high level. The Fed’s rate moves work by slowing the job market and tempering demand, which in turn force companies to increase prices more slowly to avoid losing customers.
That is what makes every new data point on spending so important. Central bankers will receive another critical piece of information about the economy on Tuesday, when the Employment Cost Index is released on the eve of their policy decision. That figure should give them a sense of whether wage growth is truly slowing, or whether it is chugging along at a rapid pace.
“I will be looking for the recent improvement in headline and core inflation to continue,” Christopher Waller, a Fed governor, said in a speech last week. Wages “are another stream of data that I will be watching for evidence of continued progress to help ease overall inflation.”
But Mr. Waller added that recent economic data had been encouraging, increasing the chances that the Fed would slow down the economy and inflation gradually and without causing a painful recession: “I am cautious about the recent good news, but it is good news.”