U.S. Labor Costs, Consumer Spending Keep Heat on Fed for Aggressive Rate Hikes

(Bloomberg) -- Accelerating U.S. labor costs and a resilient consumer are fanning inflation, effectively giving the Federal Reserve the green light to raise interest rates a half point next week to tamp down price pressures.

Data Friday showed that first-quarter employment costs rose by the most in comparable data back to the early 2000s and inflation-adjusted spending unexpectedly increased last month.

Americans are taking home more pay, and even though those wages aren't keeping pace with decades-high inflation, they aren't afraid to dig into savings to keep spending.

Economists have been watching for signs of a crumble in spending under the bite of higher prices. So far, that isn't happening, keeping recession fears at bay. Instead, demand is helping keep prices elevated, complicating the Fed's task to bring inflation -- now at 6.6% by the central bank's preferred measure -- down to its 2% target.

“We have not seen any impact on discretionary spending that we can discern,” Vasant Prabhu, chief financial officer of Visa Inc. said on an earnings call earlier this week. “If anything, discretionary spending, especially from affluent consumers and credit cardholders, has been going up quite healthily.”

The Fed has a delicate task of slowing the economy enough to dampen price pressures, but not so much as to tip it into recession.

Officials including Chair Jerome Powell have indicated a preference toward a half-point hike next week, which would be the first of that size since 2000. Traders are, however, upping wagers that the central bank will be more aggressive at its June meeting with a 75 basis-point hike in interest rates.

Against a backdrop of supply-chain bottlenecks that are still pushing up prices, it'd be in the Fed's interest to see demand cool. Real spending increased for a third month in March, indicating households still have solid appetites for shopping.

At the same time, employment costs in the first quarter rose 1.4%, the third straight month of an advance of at least 1%. That's feeding into higher prices as companies charge their customers more to offset compensation costs, as well as greater costs for materials.

“A faster than expected rise in labor costs and slightly-more-solid consumer spending leave the Fed on track to lift rates 50 basis points next week and keeps risks skewed toward more aggressive policy at future meetings,” Citigroup Inc. economists Andrew Hollenhorst and Veronica Clark said in a note.

In addition to cooling demand, the Fed also needs supply chains to normalize. That's looking increasingly difficult amid strict Covid lockdowns in China. For instance, Apple Inc. said this week that supply constraints will subtract as much as $8 billion in revenue this quarter.

Furthermore, Russia's ongoing war in Ukraine is still keeping prices for raw materials and commodities elevated and disrupting already fragile supply chains.

Those geopolitical factors are clouding the outlook. And executives, while giving glowing reviews of the U.S. consumer in the first quarter, can't predict how long the strength will last.

“Our assumptions going forward are a little bit more conservative because we think that the consumer will be feeling the overall inflation in their disposable income, and that might have an impact on the elasticities of our categories as well,” PepsiCo Inc. CEO Ramon Laguarta said this week.

There are some signs of strain. Church & Dwight Co., maker of Waterpik oral-health products and Arm & Hammer kitty litter, is seeing a shift to lower-priced goods from premium products. McDonald's Corp. says some diners are choosing less expensive menu items.

But for now, spending is holding up against inflation. It's especially strong in services like travel and dining out, as Covid restrictions lift and consumers get more comfortable living their lives again.

That's forcing consumers to dig into their savings -- in March, the savings rate fell to the lowest since 2013. Amazon.com Inc. expects the switch to services demand to weigh on profits going forward.

“Rainy day savings won't last forever, but for now at least the desire to resume service-sector activity is more powerful than inflation,” Wells Fargo & Co. economists Tim Quinlan and Shannon Seery said in note.