The persistence of inflation will be decisive in determining whether household finances are healthy enough to soften the landing of the U.S. economy.

A $2.5 trillion stockpile of excess savings, a tight labor market and rising wages continue to bolster consumers' spending power. But inflation is eating into consumer confidence, and the Federal Reserve's rate hikes will make credit card debt and mortgage repayments more expensive.

For now, economists expect consumers to weather a 40-year-high rate of inflation and prevent an economy that shrank by 1.4% in the first quarter from falling into a full recession.

. This is the second part of a series of articles examining the prospects of U.S. recession and the Federal Reserve's efforts to achieve a "soft landing" for the economy. Part 1: US Fed aims for soft landing as economists see recession odds growing Part 2: As inflation soars, consumers brace for hard landing Part 3: As cheap-money era ends, smaller companies face capital crunch Part 4: Risk management, low unemployment insulate banks in case of recession .

"Consumers have the means and ability to lever up to fund spending, but make no mistake: the highest inflation in 40-years, or for some in their lifetime, is denting sentiment and altering behavior by making tough decisions when it comes to purchases," said Shannon Seery, an economist at Wells Fargo.

From goods to services

Wells Fargo expects consumer spending to switch away from goods to services, maintaining support for the economy and jobs while easing the inflationary burden for discretionary products like cars. But a soft landing is not guaranteed.

"For sure, a cost-of-living squeeze is acting to constrain consumer spending, though in the U.S., robust income and employment growth — allied to strong consumer and business balance sheets — should help to cushion the impact of this to a much greater extent than is seen elsewhere," said Mark Dowding, CIO of BlueBay Asset Management.

Bluebay Asset Management estimates the chances of a recession over the next 18 months at 33%. "Where we see recession risk, it is linked to inflation being more persistent and the Fed needing to take rates to 4% or beyond," Dowding said.

Mixed signals

Consumers turbocharged the U.S. economic recovery in 2020 and 2021, even as the COVID-19 pandemic raged. Household finances were bolstered by a combination of government support in the form of stimulus checks and the wealth effect of rising asset values. A rapid recovery in the unemployment rate and higher wages supported spending to such an extent that battered supply chains were unable to meet demand, contributing to the burst in inflation.

The signals now are more mixed.

Consumer confidence is at an 11-year low, according to the consumer sentiment index from the University of Michigan. Weak earnings reports at U.S. retail giants Walmart Inc. and Target Corp. in May followed softening numbers of e-commerce king Amazon.com Inc. Total annualized U.S. retail sales growth slowed sharply in April to 7.3% from 17.7% in March.

Personal savings rates are also down sharply to below the pre-COVID-19 level. The March level was the lowest it had been since December 2013. Still, households have used only 1.6%, or $40 billion, of the excess savings accumulated during the pandemic, according to Oxford Economics.

"This is in addition to strong gains in net worth, although the recent pullback in equity prices will dampen some of the wealth effect and consumer sentiment," Kathy Bostjancic, chief U.S. economist at Oxford Economics, wrote in a May 26 research note. A soft landing is more likely than a recession, said Bostjancic.

Inflation cuts into income

The U.S. unemployment rate fell to 3.6% in April, after reaching 14.7% in April 2020, putting it close to the historically low pre-COVID-19 level of 3.5%. Yet real income is now below the pre-COVID-19 trend.

The good news is that low-income households most vulnerable to higher prices have been getting the biggest pay rises, and while the higher income households are seeing their real income squeezed, they have the bulk of the excess savings to lean on.

Still, vulnerabilities remain.

"I'm not sure I would say the strength of the consumer on its own can prevent a U.S. recession," Seery said. "The strength of the consumer helps offset some of the inflationary hit and perhaps effect from tightening, but it's going to require a number of factors falling favorably into place for the Fed beyond the shifting mix of spending, like a meaningful improvement in supply chains and the supply of labor."