U.S. Households Lifting Economy After Being Stung by Climbing Prices Last Year

Among the most recent evidence: Retail sales rebounded in January, rising 3% on the month after back-to-back monthly declines in November and December. Hiring surged last month and unemployment fell to a 53-year low. Filings by workers for unemployment benefits, a proxy for layoffs, held nearly steady last week and remained historically low, the Labor Department said Thursday, a sign of a tight labor market.

Several Wall Street analysts upgraded their first-quarter growth estimates in response.

The outlook is still uncertain. Annual inflation remained high, at 6.4% in January, while U.S. supplier prices rose a strong 6% on the year, according to the Labor Department.

Federal Reserve officials are still on course to keep raising interest rates to try to combat inflation by slowing the economy.

Fed officials in December projected they would lift their benchmark federal-funds rate to a range between 5% and 5.25% in 2023 and hold it there through year’s end. Earlier this year, investors disagreed, betting that slowing inflation and economic growth would lead policy makers to stop raising rates sooner and cut them later this year. By Tuesday, the recent data had prompted futures market traders to start mirroring the central bank’s expectations.

“The demand side of the economy is not weakening quite as fast as some thought it was,”

Loretta Mester,

president of the Federal Reserve Bank of Cleveland, said in a speech Thursday.

The Fed could respond to a pickup in growth and inflation by raising rates higher and holding them there longer, causing a more severe downturn later.

If companies lay off workers in response to profit pressures, household incomes could sink and spending follow, as many analysts have been predicting for months. Layoffs have already hit tech companies and other industries.

For now, the hot start to the year raises the prospect of an alternate scenario in which economic growth accelerates.

“The positive trend in incomes is going to be a source of support for this economy,” said Rubeela Farooqi, chief U.S. economist for High Frequency Economics, a forecasting firm. Ms. Farooqi has been going against a Wall Street consensus and predicting the U.S. will avoid recession this year. She said the outlook for household incomes is central to her prediction. “Wage and salary growth is now outstripping inflation.”

Ms. Farooqi estimates that total household income, adjusted for inflation and taxes, will rise at a 2.5% annual rate in the first quarter and a 2.3% rate in the second, after contracting by 6.4% last year.

Other forecasters, including economists at Goldman Sachs, J.P. Morgan, Morgan Stanley and IHS Markit are making similar income forecasts. “Workers are effectively expecting to be made whole this year,” said Chris Varvares, co-head of U.S. economics at S&P Global Market Intelligence, which projects inflation-adjusted incomes will grow at a 5.3% annual rate in the first quarter. That would be the biggest increase since early 2021, when federal pandemic relief checks were sent to millions of households.

Mr. Varvares said recent economic reports have him rethinking his recession forecast. It could come later and be milder than he thought, he said. Goldman Sachs has lowered its estimate of the probability of recession to 25% from 35%.

A great deal hangs on the path of inflation. Though high, the January rate of 6.4% marked the seventh straight monthly decline from a recent peak of 9.1% in June. If it keeps slowing, the Fed would be in a position to pause rate increases in the months ahead. But if inflation reaccelerates, then more rate increases and another hit to markets and the economy loom.

Economists surveyed by The Wall Street Journal in January projected inflation will slow to 3.1% by year-end. Average hourly earnings of private-sector workers rose 4.4% in January from a year earlier, meaning wages are potentially on track to outstrip inflation after months of falling behind. Retirees could see even more catch-up this year, thanks to an 8.7% cost-of-living adjustment for 2023 in Social Security checks.

A survey of consumers by investment bank William Blair & Co. this month found that 42.3% of households reported higher incomes than a year earlier. That’s up from 34.4% in the firm’s July survey. “The consumer still appears to be in a relatively healthy financial position,” firm’s analysts concluded.

Tyler Pack, a supplier-delivery planner at an energy company, got a promotion in December and a 10% raise starting in January. Mr. Pack went to Dairy Queen to celebrate his new position and has much bigger spending plans for the future—he’s saving to buy a Mercedes-Benz. “I hope interest rates cool,” he said, since the car-loan interest rate of 6% he was recently quoted is much higher than the 2.3% rate on his current vehicle, which he bought in late 2020. He is also planning to take a vacation in Florida this spring.

“I’m not cutting back on things, just being much more careful about where I purchase things from, “ said the 33-year old, who lives outside Pittsburgh.

Many consumers are still smarting from last year’s inflation squeeze.

Joe Wallace, of Palm Desert, Calif., received his first Social Security check in December after turning 66 last year. “I haven’t got a raise since Covid hit, I made up for it by taking Social Security,” he said.

Mr. Wallace, the chief executive of an economic development nonprofit organization, said he was pleased to get a roughly $300 increase in January, but “it’s not going to make me go out and do something I wasn’t going to do anyway.”

“That’s a Valentine’s dinner for my wife and I,” he said. Last year’s inflation drove the couple to cut down on eating out from five nights a week to three, and he has “slowed down on marginal things, like drinks and pieces of cake” at restaurants. He is also scrutinizing travel expenses like plane rides and car hires.

“Plane tickets that used to be $350 to visit new grandchildren, now they’re $900,” he said.

Mr. Wallace is considering putting off full-fledged retirement due to inflation. “It’s going to take a 50% increase in equities to get you back to where you were three years ago,” he said.

“People save all their lives and then this thing comes along,” he said, referring to the pandemic, “and inflation follows it and the security in your mind goes away.”

Jim Vespe, a 74-year-old retiree in Mamaroneck, N.Y., described the bump in his Social Security check as nice but not life changing. After the drop in his stock portfolio last year, he said, the added income this year might convince him to buy a sweater or a dinner out, but not much more than that. “Most of us had a bad year last year,” he said.

Household income has been exceptionally volatile in recent years, a symptom of broader economic turbulence unleashed by Covid-19 and then the government’s response to it. Incomes adjusted for taxes and inflation jumped in 2020 and early 2021, thanks to relief checks, then tumbled in 2022 as the aid programs ended and inflation soared to a 40-year high.

Another source of support for households are state tax cuts and aid. During 2020 and 2021, 43 states cut individual income taxes and a dozen are considering additional individual cuts this year, according to the Tax Foundation, a nonprofit specializing in tax policy research. More than a dozen states issued rebates and refunds in 2022.

State tax collections are up 9% over the past three years and many forecasters see continued growth in 2023, said

Jared Walczak,

a Tax Foundation state budget analyst.

“States tend to have the capacity to share some of this revenue growth back with taxpayers and often feel compelled to do so,” he said. The rise of remote work has made it easier for workers and employers to pick up and leave when they feel state tax rates are unappealing.

Write to Jon E. Hilsenrath at Jon.Hilsenrath@wsj.com and Harriet Torry at harriet.torry@wsj.com

Among the most recent evidence: Retail sales rebounded in January, rising 3% on the month after back-to-back monthly declines in November and December. Hiring surged last month and unemployment fell to a 53-year low. Filings by workers for unemployment benefits, a proxy for layoffs, held nearly steady last week and remained historically low, the Labor Department said Thursday, a sign of a tight labor market.

Several Wall Street analysts upgraded their first-quarter growth estimates in response.

The outlook is still uncertain. Annual inflation remained high, at 6.4% in January, while U.S. supplier prices rose a strong 6% on the year, according to the Labor Department.

Federal Reserve officials are still on course to keep raising interest rates to try to combat inflation by slowing the economy.

Fed officials in December projected they would lift their benchmark federal-funds rate to a range between 5% and 5.25% in 2023 and hold it there through year’s end. Earlier this year, investors disagreed, betting that slowing inflation and economic growth would lead policy makers to stop raising rates sooner and cut them later this year. By Tuesday, the recent data had prompted futures market traders to start mirroring the central bank’s expectations.

“The demand side of the economy is not weakening quite as fast as some thought it was,”

Loretta Mester,

president of the Federal Reserve Bank of Cleveland, said in a speech Thursday.

The Fed could respond to a pickup in growth and inflation by raising rates higher and holding them there longer, causing a more severe downturn later.

If companies lay off workers in response to profit pressures, household incomes could sink and spending follow, as many analysts have been predicting for months. Layoffs have already hit tech companies and other industries.

For now, the hot start to the year raises the prospect of an alternate scenario in which economic growth accelerates.

“The positive trend in incomes is going to be a source of support for this economy,” said Rubeela Farooqi, chief U.S. economist for High Frequency Economics, a forecasting firm. Ms. Farooqi has been going against a Wall Street consensus and predicting the U.S. will avoid recession this year. She said the outlook for household incomes is central to her prediction. “Wage and salary growth is now outstripping inflation.”

Ms. Farooqi estimates that total household income, adjusted for inflation and taxes, will rise at a 2.5% annual rate in the first quarter and a 2.3% rate in the second, after contracting by 6.4% last year.

Other forecasters, including economists at Goldman Sachs, J.P. Morgan, Morgan Stanley and IHS Markit are making similar income forecasts. “Workers are effectively expecting to be made whole this year,” said Chris Varvares, co-head of U.S. economics at S&P Global Market Intelligence, which projects inflation-adjusted incomes will grow at a 5.3% annual rate in the first quarter. That would be the biggest increase since early 2021, when federal pandemic relief checks were sent to millions of households.

Mr. Varvares said recent economic reports have him rethinking his recession forecast. It could come later and be milder than he thought, he said. Goldman Sachs has lowered its estimate of the probability of recession to 25% from 35%.

A great deal hangs on the path of inflation. Though high, the January rate of 6.4% marked the seventh straight monthly decline from a recent peak of 9.1% in June. If it keeps slowing, the Fed would be in a position to pause rate increases in the months ahead. But if inflation reaccelerates, then more rate increases and another hit to markets and the economy loom.

Economists surveyed by The Wall Street Journal in January projected inflation will slow to 3.1% by year-end. Average hourly earnings of private-sector workers rose 4.4% in January from a year earlier, meaning wages are potentially on track to outstrip inflation after months of falling behind. Retirees could see even more catch-up this year, thanks to an 8.7% cost-of-living adjustment for 2023 in Social Security checks.

A survey of consumers by investment bank William Blair & Co. this month found that 42.3% of households reported higher incomes than a year earlier. That’s up from 34.4% in the firm’s July survey. “The consumer still appears to be in a relatively healthy financial position,” firm’s analysts concluded.

Tyler Pack, a supplier-delivery planner at an energy company, got a promotion in December and a 10% raise starting in January. Mr. Pack went to Dairy Queen to celebrate his new position and has much bigger spending plans for the future—he’s saving to buy a Mercedes-Benz. “I hope interest rates cool,” he said, since the car-loan interest rate of 6% he was recently quoted is much higher than the 2.3% rate on his current vehicle, which he bought in late 2020. He is also planning to take a vacation in Florida this spring.

“I’m not cutting back on things, just being much more careful about where I purchase things from, “ said the 33-year old, who lives outside Pittsburgh.

Many consumers are still smarting from last year’s inflation squeeze.

Joe Wallace, of Palm Desert, Calif., received his first Social Security check in December after turning 66 last year. “I haven’t got a raise since Covid hit, I made up for it by taking Social Security,” he said.

Mr. Wallace, the chief executive of an economic development nonprofit organization, said he was pleased to get a roughly $300 increase in January, but “it’s not going to make me go out and do something I wasn’t going to do anyway.”

“That’s a Valentine’s dinner for my wife and I,” he said. Last year’s inflation drove the couple to cut down on eating out from five nights a week to three, and he has “slowed down on marginal things, like drinks and pieces of cake” at restaurants. He is also scrutinizing travel expenses like plane rides and car hires.

“Plane tickets that used to be $350 to visit new grandchildren, now they’re $900,” he said.

Mr. Wallace is considering putting off full-fledged retirement due to inflation. “It’s going to take a 50% increase in equities to get you back to where you were three years ago,” he said.

“People save all their lives and then this thing comes along,” he said, referring to the pandemic, “and inflation follows it and the security in your mind goes away.”

Jim Vespe, a 74-year-old retiree in Mamaroneck, N.Y., described the bump in his Social Security check as nice but not life changing. After the drop in his stock portfolio last year, he said, the added income this year might convince him to buy a sweater or a dinner out, but not much more than that. “Most of us had a bad year last year,” he said.

Household income has been exceptionally volatile in recent years, a symptom of broader economic turbulence unleashed by Covid-19 and then the government’s response to it. Incomes adjusted for taxes and inflation jumped in 2020 and early 2021, thanks to relief checks, then tumbled in 2022 as the aid programs ended and inflation soared to a 40-year high.

Another source of support for households are state tax cuts and aid. During 2020 and 2021, 43 states cut individual income taxes and a dozen are considering additional individual cuts this year, according to the Tax Foundation, a nonprofit specializing in tax policy research. More than a dozen states issued rebates and refunds in 2022.

State tax collections are up 9% over the past three years and many forecasters see continued growth in 2023, said

Jared Walczak,

a Tax Foundation state budget analyst.

“States tend to have the capacity to share some of this revenue growth back with taxpayers and often feel compelled to do so,” he said. The rise of remote work has made it easier for workers and employers to pick up and leave when they feel state tax rates are unappealing.

Write to Jon E. Hilsenrath at Jon.Hilsenrath@wsj.com and Harriet Torry at harriet.torry@wsj.com