Consumer spending tops forecasts

August gain comes despite mortgage, housing woes; key inflation reading improves.

By Chris Isidore, CNNMoney.com senior writer

September 28 2007: 11:00 AM EDT

NEW YORK (CNNMoney.com) -- Consumer spending stayed strong in August, despite the problems in mortgage and real estate markets that some feared would put a brake on Americans' willingness to open their wallets, according to a government report issued Friday.Spending by consumers rose 0.6 percent in August, an improvement from the 0.4 percent rise in July.

Economists surveyed by Briefing.com had forecast another 0.4 percent rise in August.
The solid gain in spending came even as individuals' incomes rose by only 0.3 percent in August, down from the 0.5 percent rise in July. That was a bit weaker than economists' forecast of a 0.4 percent rise in income in the period.

The Commerce Department report also included a key inflation reading, the so-called core PCE deflator, which measures prices paid by individuals for goods other than food and energy.

The Federal Reserve is believed to want to see that reading post between a 1 and 2 percent increase on a year-over-year basis. The August report showed a 1.8 percent rise on that basis, after a 1.9 percent rise in the previous readings for both June and July.

That would appear to give a green light to the Fed if it should decide it wants to cut interest rates again at its next meeting Oct. 31.

"If the Fed wants to cut, inflation isn't going to enter into the equation," said Gus Faucher, the director of macroeconomics for Moody's Economy.com.

Still strong consumer spending is also suggesting that the risk of a slowdown in the economy may be less than many economists and the Fed believed when the central bank cut interest rates by a half percentage point earlier this month.

Spending by consumers is crucial to the nation's economic growth, accounting for nearly three quarters of economic activity.

David Kelly, economic advisor for Putnam Investments, said he now believes that the economy will at least initially show annual growth above 3 percent in the third quarter.

The first estimate of third quarter gross domestic product, the broadest measure of U.S. economic activity, is due out Oct. 31, the same day as the Fed meets. It's possible that strong growth in that report could convince the Fed another cut isn't warranted at that time. Some economists are already questioning need for another cut.

"It's clear that consumers aren't rolling over any time soon. A worst case scenario is that consumers will be spending at more than twice the pace of increase in the third quarter that they did in the second," said Rich Yamarone, director of economic research at Argus Research. "A Fed rate cut in this scenario is like pouring gasoline on a fire. That blows up in your face."

But Faucher said that early indications are that major retailers are seeing tougher sales in September after a very strong August. No. 2 discount retailer Target (Charts, Fortune 500) warned on Tuesday it now expects softer than expected September sales.

In addition, two readings on consumer confidence this week, one on Tuesday from the Conference Board, the other on Friday from the University of Michigan, both showed confidence falling more than forecast this month.

So Faucher and David Wyss, chief economist with Standard & Poor's, said the strong consumer spending report for August doesn't necessarily mean that a slowdown in consumer spending and the economy as a whole still doesn't lie ahead.

"The question is if this spending will hold up, given what's going on in the labor market," said Faucher, pointing to the fact that August saw the first decline in U.S. payrolls in four years.

"A lot of the growth [in spending] is because auto sales rebounded from miserable levels in July and because it was so hot, which prompted consumers to run their air conditioners," said Wyss. "So I think we need another one or two more rate cuts may not be a bad idea at this point. Certainly the inflation numbers in this report are very encouraging for the Fed."