October 28, 2022
Consumer sentiment is currently far below the level that existed when COVID was spreading rapidly in the spring of 2020, and is roughly on a par with where it was when the economy was experiencing the so-called “Great Recession” in 2008-09. Typically when sentiment plunges consumer spending takes a dive That isn’t happening. But that raises a question. If we are as scared as we seem to be, why are we still spending? Do we have no fear of losing our job any time soon? Are consumers’ balance sheets in such good shape that we feel comfortable maintaining our pace of spending? Are interest rates not yet high enough to bite? Yes. Yes. And yes.
Consumer sentiment data are published monthly by the University of Michigan. They are generally regarded as a good barometer of consumer angst or euphoria. After reaching a post-recession peak of 88.3 in April of last year it began a steady slide to a record low level of 50.0 in June of this year.
It is abundantly clear what is bothering us – inflation. After a steady diet of monthly increases of 0.1-0.2% in the second half of 2020, the core CPI took off in February 2021 and jumped 0.5-0.9% every month for the next six months.
The Fed told us at that time that the run-up was the result of supply constraints which would eventually disappear and that the inflation increase would prove to be temporary. The American public was less convinced and sentiment went into a freefall. The Fed did not begin to raise the funds rate until January 2022. It was very late to the party and had to play catch-up. Without a doubt some of the sharp slide in sentiment in the second half of last year was exacerbated by a sense that the Fed was not doing its job.
A run-up in inflation is more troublesome to the American consumer than increases in interest rates. For example, there is $16.2 trillion of consumer debt outstanding of which $11.4 trillion or 70% is mortgage-related debt. But an increase in mortgage rates only affects home buyers. Most of the homeowners who hold $11.4 trillion of mortgage debt have fixed-rate mortgages. An increase in interest rates does not bother them.
Ditto for auto loans. They are $1.9 trillion and represent 9% of the total. But the rate on those loans is fixed. If rates rise most automobile owners are unaffected. Only those who have to purchase a new or used car will be impacted.
The point is that an increase in interest rates only affects a relatively small number of consumers.
That is not the case for inflation. It affects all of us when we go to the grocery store or fill up the car with gas. Food prices have risen 11% in the past year. Energy prices have risen 20%. We cannot escape them. We have to eat. We have to drive to work.
While the all-encompassing nature of rapidly rising inflation may explain why consumer sentiment has fallen far more sharply this time than in other interest rate triggered downturns, it still does not explain why spending has not declined. Real consumer spending keeps rising steadily. In the past year it has risen 1.4%. In other cycles a similar drop in confidence caused a dramatic pullback in spending. We may say we are scared, but we are not behaving as if that is the case.
We would suggest that a large part of the answer is that we are not yet worried about our job. At 3.5% the unemployment rate is the lowest in 50 years. Job openings at 10.0 million are far higher than they were prior to the recession. If we should lose our job it will be easy to find another. If we thought that we might soon lose our job and our income stream would be interrupted, paying our monthly bills would quickly become a challenge. In that situation we would behave differently and spend more cautiously.
In addition, consumer balance sheets are in excellent shape. It appears that a significant portion of those stimulus checks in 2020 and 2021 were used to pay down debt. If we take the sum of our monthly payments on the rent or mortgage, auto loans, credit cards, and student loans as a percent of income, it is the lowest it has been since the mid-1980’s. Compare that situation to what existed going into the 2008-09 recession where consumers were highly leveraged. A job loss combined with a high level of debt can be devastating. The consequences are less troublesome with a smaller amount of debt. Consumers are in a position that they can choose to borrow or run up credit card debt temporarily if they are having trouble making ends meet. That was not the case 14 years ago.
Finally, we continue to harp on the notion that the real funds rate is still negative. If the funds rate ends this year at 4.4% and the core CPI for the year is 5.6%, the real funds rate at the end of the year will still be negative by 1.2%. In 2008-2009 the real rate needed to be 3.0% before the economy finally began to sink. In 1979 the real rate needed to be 8.0% because supercharged inflation was so entrenched. Nominal interest rates are high. Real interest rates are not. Negative real interest rates are not going to slow the economy enough that inflation begins to retreat.
It is abundantly clear that consumers are nervous about what lies ahead. Rates will continue to climb and may not peak until the spring of next year. Inflation is showing little evidence of turning down. Virtually every economist expects a recession at some point in the not-too-far-distant future. When the Fed embarks on these extended tightening cycles it almost invariably ends in tears. There have been 12 rate tightening cycles since 1960. Nine of the 12 have ended in a recession. In the other three cases the increase in the funds rate was less than 3.0%. By the end of this year the funds rate will have risen 4.4%. While a soft landing is not impossible, the odds on it actually happening are low. The Fed does not have a great track record.
While consumers are clearly fearful, they will continue to spend until such time as employers decide they can no longer keep workers on the payroll. Once employment declines and the unemployment rate starts to rise, consumers may decide that it is time to re-assess their spending habits and cut expenditures as best they can. That is when the recession will begin. We expect that to happen in early 2024 and continue through the middle of that year. At that point inflation will bid a hasty retreat and the Fed will quickly reduce the funds rate. Unfortunately, the spring of 2024 is still a long ways down the road and we will continue to worry about a recession until it actually happens.