What this means for stocks

• Americans have begun to tighten their belts in the face of inflation and rising interest rates.
• The slowdown in spending could come sooner than the Fed expects and could signal a recession.
• Here’s why spending is likely to slow, and why that could spell more turmoil for markets.

Americans appear poised to start pulling back on spending as the effects of inflation and rising interest rates finally begin to bite.

Retailers and others believe consumer spending is likely to fall after the first weeks of 2023 begin to pick up.

Over the past year, the Federal Reserve has raised interest rates from near zero to nearly 5%, in part to encourage spending savings while trying to cool red-hot inflation,

Consumer spending has proved remarkably resilient in the face of all this. Wage inflation has offset much of the pain from price inflation, especially given the rapid job growth, according to Bank of America’s Aditya Bhave.

“But as this momentum slows, even if price inflation comes down a bit, you’ll see consumers start to tighten their belts,” the bank’s senior economist said.

The Fed may still stick with its aggressive monetary policy tightening. That could mean a recession and more turmoil for the markets, say some analysts.

What happens?

Economic data showed Americans were still out spending in the first weeks of 2023, well past the nearly three years after a historic ride began in the wake of stimulus packages handed out during the onset of the COVID-19 pandemic.

Bank of America analysts found that household credit and debit card spending rose more than 5% in the year to January. Meanwhile, the Fed’s preferred PCE inflation gauge showed a 1.8% jump in consumer spending that month compared to December.

That suggests the central bank’s aggressive rate hikes over the past year have yet to cool demand — a “very worrying” development that makes a recession more likely, according to former Treasury Secretary Larry Summers.

But the trend in spending may be about to reverse.

Top retailers Target, Macy’s and Best Buy have all said they are preparing for people to cut back on spending in 2023, noting that shoppers are actively looking for discounts.

The latest US credit and debit card data for February also suggests that spending is slowing, Bhave told Insider.

Why?

American households are feeling the rising prices of everyday food, and it may make them think twice about opening their wallets.

Target CEO Brian Cornell said his company saw a noticeable shift in grocery aisles.

“Rising inflation forced families to put discretionary purchases on hold and focus most of their spending on necessities,” Cornell said in an earnings call.

David Marcotte, a senior VP at Kantar Retail, suggested that broad-based pricing pressure is not driving the shift.

“On the consumer side, they keep running into the one item that sticks in their head,” Marcotte told CNBC. “Right now eggs—which I can’t imagine—eggs are like the big item. That’s what they’re benchmarking.”

It’s fair to say that most analysts didn’t expect consumer spending data to be so robust in January – and some suggest those numbers may be exaggerated.

Ryan Sweet, chief US economist at Oxford Economics, said there were some factors last year that meant the rise in spending could be a “flash in the pan”. They include the milder weather and cost of living adjustments.

“I think the data for February and March will most likely be much weaker than what we saw in January from a consumer spending perspective,” Sweet told Insider.

Meanwhile, Wells Fargo calculates that Americans have 10 months of purchasing power left if they continue to tap into their savings at the current rate.

But Sweet believes the data can be misleading, as it’s mostly hoarded by wealthier households who aren’t as likely to use it as those on lower incomes.

What does this mean for the markets?

A dip in consumer spending could signal the beginning of a sustained decline in demand in the US. But there are concerns that the decline could come faster than the Fed expects.

The central bank’s higher rates have pulled down asset prices and sent shares lower, as they ultimately mean less profit for companies. Major U.S. stock indexes fell in 2022 as investors worried the Fed would tip the economy into recession.

“The Fed will be fine with a slowdown in consumer spending, even to the extent we’re seeing,” Bhave said, noting that Bank of America expects a mild recession in the third quarter of 2023.

“They won’t officially say they’re going to cause a recession. But they’ve essentially indicated they’d be okay with the recession, because that’s how you get inflation back to 2%.”

Sweet concerns the wave of positive but temporary data has made Fed Chairman Jerome Powell overly nervous about inflation.

He expects three more 25 basis point hikes this year, but has not ruled out a “shock and awe” moment of a 50 basis point increase at policymakers’ next meeting.

“They want to break something. They want to break inflation, which is their goal. But unfortunately, they can also break the economy,” Sweet said.

“That’s a big risk to the forecast — that the Fed moves more aggressively than either the markets or we expect, and that pushes us into a mild recession.”