Is the US finally succumbing to higher rates?

This has been frustrating for the US Federal Reserve (Fed), as the central bank needs to cool down the economy to bring inflation back to its target level of 2% a year. It has been forced to keep rates ‘higher for longer’ as a result.

The Fed’s preferred inflation measure is the Personal Consumption Expenditures (PCE) price index. Unlike the Consumer Price Index (CPI), which is based on a survey of consumer purchases, the PCE price index tracks consumer spending and prices through the business receipts used to calculate gross domestic product (GDP).

The CPE measure accounts for changes in consumer behaviour such as substituting less expensive items for costlier alternatives and has a wider scope than the CPI. In April, personal income increased 0.3% on the month, matching expectations, while spending rose just 0.2%, below the 0.4% estimate.

So, consumption in the US has started to ease. Official numbers are showing retail sales are still running at reasonable levels. However, signs are emerging that indicate the US consumer may be about to succumb to the financial pressures brought by higher rates.

The quarterly reporting season for the first three months of 2024 saw some companies reporting signs of a slowdown and, in the early days of reporting in the second quarter, these trends looks like they is being repeated.

One such business was coffee chain Starbucks, which posted its first year-on-year quarterly sales decline since the Covid-19 pandemic in the first quarter with the second quarter too saw too demonstrating falling sales. Its management was forced to downgrade guidance for the full year as customers made fewer transactions in its stores. This trend likely reflects shifts in American coffee consumption, as consumers increasingly look for cheaper options. These comments were echoed in statements for other US consumer-facing companies.

Seeking cheaper alternatives

Another Main Street stalwart, McDonald’s, has seem similar trends emerging in its network of stores. The group’s first quarter results were impacted by a reorganisation but missed market expectations. Its management warned that its customers were becoming more cautious and the company ended up missing market expectations. “Consumers continue to be even more discriminating with every dollar that they spend as they faced elevated prices in their day-to-day spending, which is putting pressure on the industry”, chief executive Chris Kempczinski noted.

Other fast food groups managed to keep cost-conscious customers by offering value items on their menu. But McDonald’s has been increasing prices to make up for higher costs, with the consumer voting with their feet. It is yet another ‘trading down’ story.

Consumers are making “tough choices with their budgets”, Best Buy chief executive Corie Barry said on its first-quarter earnings call. “Three months ago, there were several indicators showing some favourability, including decreasing inflation, continued low unemployment, encouraging trends in consumer confidence and the beginnings of a housing market rebound”, Mr Barry said. “Since then, inflation is still high, mortgage rates are high and consumer confidence scores are trending lower”, he added. Indeed, its second quarter results came in lower than market expectations

Even the mighty Amazon is not immune to this trend, with its chief executive Andy Jassy saying consumers are trading down on average selling price. The Fed will be keen to hear such comments during the current earnings reporting season.

Interest costs hit home

While travellers have ensured that crossborder transactions have proved resilient for Mastercard, the credit card group is seeing a slowdown in the number of consumer transactions. Volumes continued to grow in the first three months of 2024 but, as with the previous quarter, growth continued to moderate.

High credit card balances are also forcing a slowdown, as it reduces the capacity to spend. Indeed, the share of credit card debt that’s severely delinquent – more than 90 days overdue – rose to 10.7% in the first quarter of 2024, according to the Federal Reserve Bank of New York. This compared with a figure of 8.2% in the equivalent period of 2023.

Now we are seeing a marked slowdown in consumer credit partly because banks are being more restrictive due to the pressures on the consumer. Indeed, recent data revealed that Americans are spending almost as much on credit card interest and other kinds of consumer debt as they are interest on their mortgage.

It is getting to a point where households that need to move house must refinance their mortgage – and must do so at significantly higher rates than their previous deal. There has been a significant lag time in this effect, as it is a choice to move home, but many can’t delay this any longer as they need to move for work or family commitments.

This will add to the burden of interest payments and is likely to reduce disposable income.

A helpful showdown

The view from the Fed is that a slowdown would be helpful, as the resulting discounting in goods prices will continue to drive inflation down, but this must be maintained to complete the task of getting inflation back to target levels – and keeping it there. The problem remains wages and services inflation, which is still seeing some healthy support and remains the sticky side of the inflation story.

It remains unclear when US interest rates will start to come down. Markets have been overly optimistic on the prospects of a Fed rate cut for quite some time. However, if we are really starting to see a capitulation of the mighty US consumer, the central bank will feel more confident that it can ease off the fiscal brakes. Further signs that households are worrying about their future finances and containing their spending as a result are likely to be welcomed by the Fed. In fact, we need to see these signs before interest rates can be cut.