Consumer Spending Climbs 0.7% as Inflation Hits Three-Year High

Quick Facts

Personal consumption expenditures rose 4.1% year-over-year in May, more than double the Fed’s 2% target.
Consumer spending and personal income both grew 0.7%, but the savings rate dropped to 3%, the lowest since 2022.
The Fed’s latest projections push rate cuts to 2027 and 2028, with traders pricing in an 80% chance of a rate hike by year-end.

U.S. consumers kept spending in May despite accelerating inflation, according to data released Thursday by the Bureau of Economic Analysis. Personal spending rose 0.7%, matching a 0.7% gain in personal income. The personal consumption expenditures index climbed 4.1% annually, the highest reading since April 2023 and more than twice the Federal Reserve’s 2% target.

Core PCE, which strips out food and energy, rose 3.4% from a year ago. A closely watched services inflation metric excluding energy and housing advanced 0.5% in May, the most since January. Financial services, transportation, and healthcare all posted strong price increases.

Computer software and accessories prices jumped a record 14.5% year-over-year, driven partly by data center demand. Inflation-adjusted goods spending rose on strength in motor vehicles and household furnishings. Real services spending gained 0.2%, weighed down by declines at restaurants and in transportation.

The Iran war and closure of the Strait of Hormuz sit behind much of the inflation surge. The International Energy Agency called it the largest supply disruption in the history of the global oil market. Energy prices have rippled into nearly every spending category.

Despite the headline spending strength, consumers are showing strain. Real disposable income rose just 0.3% in May, the first increase since the start of the year. The savings rate held at 3%, matching its lowest level since 2022.

“Consumers are increasingly facing an income squeeze, which is forcing them to use savings, credit and wealth to sustain their spending patterns,” said Gregory Daco, chief economist at EY-Parthenon.

The spending outlook is uneven across income groups. NRF Chief Economist Mark Mathews said higher-income households are driving the majority of growth. “The spending outlook is still bifurcated between higher- and lower-income consumers,” Mathews said.

Lowe’s CEO Marvin Ellison offered a similar read at a recent conference. “This is a healthy consumer, but the broader macro is giving them a bit of hesitation,” he said.

The labor market remains a stabilizing force. Initial jobless claims fell 12,000 last week to 215,000. Nonfarm payrolls grew by 172,000 in May, beating expectations, while the unemployment rate held at 4.3%.

LPL Financial Chief Economist Jeffrey Roach said labor conditions are key to the spending outlook. “If the labor market holds, we expect consumers will have the ability to maintain spending patterns,” he said. Roach added that if the Iran conflict extends into fall, “inflation pressures will seep into other categories and will force the Fed’s hand.”

The Federal Reserve has responded by erasing its earlier projection for a 2026 rate cut. The median funds rate projection for year-end now stands at 3.8%, signaling a possible hike. Most officials expect the benchmark rate to land between 3.6% and 4.1% by December, up from a prior forecast of 3.25% to 3.75%. Rate reductions are now penciled in for 2027 and 2028, on a slower path than previously expected.

Traders in interest rate futures put 80% odds on at least a quarter-point hike by year-end, up from 68% a month ago. J.P. Morgan Global Research sees the Fed staying on hold through 2026 before hiking 25 basis points in September 2027.

RSM US Chief Economist Joe Brusuelas said the sharp drop in oil prices since May suggests inflation may have peaked. But underlying price pressures, he noted, “will not retreat so easily” given what remains in the pipeline.

The Atlanta Fed’s GDPNow model estimates second-quarter real GDP growth at 2.5%, with real personal consumption expenditures growth tracking at 2.0%. First-quarter GDP was revised up to 2.1% annualized, though the gain largely reflected a downward revision to imports.