Is US consumer spending fueling inflation or keeping it in check?

The average US consumer is still spending like never before. Recent data shows American spending remains robust, even as inflation is cooling, pointing towards an economy that may be headed for a unique combination of strong demand and controlled prices. 

But this growth comes with its own set of complexities.

Is the consumer spending boom helping to tame inflation, or could it bring about new challenges for the Federal Reserve and the economy as a whole?

Consumer spending is the economy’s fuel

Consumer spending, which drives about 68% of the US GDP, showed strong growth in the third quarter, with a 3.7% annualized increase. 

According to the Bureau of Economic Analysis (BEA), this spending contributed a significant 2.46 percentage points to the GDP’s 2.8% rise, the fastest pace since early 2023.

Americans continue to buy, dine out, and travel, even as other parts of the economy, like housing, slow down.

Rising disposable income is a key factor in this spending resilience. September’s income data showed a steady growth rate, driven by low unemployment and wage gains, even as inflation pressures ease.

Real spending rose by 3.1% over the year, supported by a similar rise in real disposable income.

The core Personal Consumption Expenditures (PCE) index, which excludes food and energy prices, rose by 2.7% year-over-year in September.

This was higher than the forecasted 2.6% and marked the largest monthly increase since April.

Cooling inflation, but is it stable?

The overall PCE inflation, which includes food and energy, stood at 2.1% in September, the lowest since early 2021. 

This reduction in inflation aligns with recent energy price drops, particularly oil, which has played a large role in keeping inflation in check.

However, core inflation’s stubborn hold at higher levels indicates the impact of consumer demand on prices.

While prices are still high, income growth is starting to outpace price increases.

This trend could ease the cost of living for many Americans in the months ahead, lessening inflationary pressure.

Yet, the risk remains that any spike in energy prices or supply chain disruptions could reignite inflation.

Despite this potential instability, the Fed took a significant step last month by cutting interest rates by half a point, bringing the rate to a range of 4.75%-5.00%.

Another smaller cut of a quarter-point is anticipated in the Fed’s upcoming meeting on November 6-7. 

What’s behind the rise in imports and inventory levels?

Another point of interest in the latest economic data is the spike in imports. 

The recent GDP report revealed an unusual rise in imported goods, a factor that has historically contributed to inflation by affecting the trade balance.

Some analysts suggest that businesses may have front-loaded imports in anticipation of a potential dockworkers’ strike. 

Others believe high consumer demand is naturally driving more imports, with categories like pharmaceuticals and computing equipment—particularly those tied to AI and health tech—seeing substantial gains.

Economists argue that consumer demand is now a stronger predictor of the economy’s performance than net exports or government spending, as these areas tend to fluctuate. 

The surge in tech-related imports, including Nvidia chips for AI applications and pharmaceuticals tied to popular diet drugs, may now be substantial enough to meaningfully shape the US GDP.

The Fed’s next steps

For Fed policymakers, managing inflation while sustaining consumer confidence will be challenging.

The resilient job market, steady wage growth, and recent strikes have further strengthened the labor sector, giving consumers more income to spend.

A major factor influencing economic stability in the near term will be the results of the presidential election.

According to a recent report, some analysts expect the election may increase market uncertainty, with potential policy changes in taxes and spending depending on the outcome.

For now, consumer confidence is climbing. The University of Michigan’s Survey of Consumers shows sentiment at its highest since April, reflecting optimism about stable incomes and easing borrowing costs.

However, a potential policy misstep could impact this confidence and disrupt economic stability.

The surprising winners of consumer spending

An interesting development in this consumer spending wave is its impact on utilities, particularly those supplying power to the booming data center industry. 

Data centers across the US are driving high electricity demand, particularly in areas like Virginia, which hosts some of the country’s largest data hubs. 

While utilities typically see slow, predictable growth, the AI industry’s hunger for power has turned some utilities into high-growth companies. 

However, the gains come with risks. AI adoption could slow, or new supply could drive down prices.

For now, though, utility companies with strong ties to tech centers appear well-positioned to capitalize on the trend.

Will the spending boom continue?

Looking ahead, a few key factors may affect the consumer spending surge. 

First, upcoming tax policy changes could either support or dampen spending. If Democrats succeed in expanding the Child Tax Credit, consumer spending could see a boost. 

The Penn Wharton Budget Model estimates this could cost $1.6 trillion over the next decade, adding momentum to consumer spending.

Alternatively, a Republican win could lift the cap on state and local tax (SALT) deductions, a change that could free up another $1.2 trillion.

Meanwhile, some economists are already predicting a modest slowdown in spending next quarter.

The expiration of the 2017 individual tax cuts in 2025 could impact after-tax incomes significantly.

According to the Congressional Budget Office, this could reduce personal consumption by $290 billion in 2026 if the cuts are not extended.

Yet, barring any major policy shifts, the consumer sector remains strong. The current combination of rising disposable income, moderate inflation, and solid job growth suggests consumers have room to keep spending into 2025. 

The Fed will be watching closely for signs of change in consumer behavior as it plans further rate cuts, with analysts predicting another quarter-point cut in December if economic data supports it.