Strong December spending amid only modest inflation

Summary

Despite stronger-than-expected consumer spending in December, the Fed's preferred gauge of underlying inflation rose only slightly putting the year-over-year rate at 2.8%. We explore the challenge of sustaining robust activity while still finishing the job of bringing down inflation.

Nobody said it was easy

Policymakers at the Federal Reserve this week signaled a willingness to sit tight for now after having cut the fed funds rate 100 basis points since September. A key challenge in setting short-term interest rates is whether inflation remains on a glide path toward the 2.0% target. Among the various ways inflation could creep back up, two that stand out are tariffs and sustained demand in the service sector.

The Fed might look-through the tariff impact if it is seen as a temporary driver, but it is less apt to ignore services inflation. Consumers themselves tend to be less discerning about the drivers yet acutely aware that inflation has not gone away. When asked about where they expect inflation to run over the longer term in a recent survey from the University of Michigan, consumers' expectations rose to 3.2%, the highest since the financial crisis in 2008.

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