Consumer sentiment isn’t enough to gauge economic outlook
The January 2024 Economics Insider explores how consumer sentiment and economic conditions, which earlier used to move in tandem, have parted ways since the pandemic.
In June 2022, the University of Michigan’s index of consumer sentiment dropped to 50, the lowest on record since the monthly surveys started in 1978.1 The last time the index came close to this level was during the recession of January to July 1980. For economists who view the index of consumer sentiment and its fellow measure, the Conference Board’s consumer confidence index, as signals of how consumers and the wider economy are doing, the dip in the index of consumer sentiment in 2022 and its relatively subduedness since then is a puzzle. For unlike sentiment, as captured by the Michigan survey, the economy has been growing steadily aided by strong consumer spending.2
There are likely multiple reasons for this dichotomy. The Michigan survey puts greater emphasis on inflation compared to the Conference Board’s measure, which focuses more on the labor market. So, as inflation surged in mid-2022, the index of consumer sentiment (ICS) dropped more than the Conference Board’s consumer confidence index (CCI). The other reason is more behavioral in nature. The pandemic weighed heavily on people’s minds in 2020 and 2021, thereby impacting both measures of consumer sentiment negatively. Also, in an era of widespread access to social media, bad news tends to be more in focus and is likely to have dented sentiment more than in previous decades.
Consumer sentiment and economic activity are not in sync
Figure 1 shows the CCI and the ICS since January 1980. Sentiment tends to decline during recessions, often edging lower even before a downturn starts. Take the recession of 2007–2009,3 for example, when worries about financial stability started denting consumer sentiment even before the onset of recession. Figure 1 also reveals that once the worst of a downturn is over, sentiment picks up and remains elevated through all recoveries—all except the current one. The University of Michigan’s index picked up after the recession of 2020, but lost steam again from mid-2021 and dropped sharply in 2022 (much more than the decline in the Conference Board’s measure). For someone used to the University of Michigan’s index as a bellwether of the economy, the trend and levels of the ICS in 2022 would have even hinted at an impending recession. Instead, the economy has grown steadily, with consumer spending now 9.8% higher than prepandemic levels.
Methodology may be weighing on sentiment as measured in the Michigan survey
The Michigan survey has a question to gauge intentions for buying large household durable goods, which is influenced greatly by inflation.4 The Conference Board’s survey doesn’t have such an explicit question on inflation. Consequently, the ICS is more influenced by current inflation trends than the CCI. The labor market, however, is addressed more directly in the Conference Board’s survey5 and, hence, influences CCI readings more than the ICS. These differences explain the gap between the two measures of consumer sentiment from 2021. As inflation started picking up in 2021, the ICS fell, but due to strong jobs creation and low unemployment, the CCI remained relatively more upbeat. A similar trend, albeit to a lesser degree, is also evident in the period between 2016 and 2019 when inflation had gone up, but unemployment kept declining (figure 2). The inability of the University of Michigan’s index to account for the impact of a strong labor market, according to economists at the Federal Reserve Bank of Chicago, is a key factor weighing on the index’s ability to be in sync with economic growth.6
Behavioral factors at play
While inflation and labor market conditions may help explain why the University of Michigan’s index has remained relatively subdued compared to the Conference Board measure, it doesn’t fully explain why both indicators are relatively low compared to the year prior to the pandemic. There are likely two explanations, and both are behavioral in nature. The pandemic was a once-in-century health crisis with no close comparisons other than the Spanish Flu of 1918. This likely continued to weigh on people’s minds7 even when economic fundamentals improved. The emergence of deadly variants of COVID-19 throughout 2020 and 2021 also likely led to “recency bias”—a tendency to put too much emphasis on recent events—and hence, played a part in keeping consumers wary.8
Second, compared to previous decades, the world is far more interconnected due to the widespread use of the internet and social media. Bad news, including “fake” news, travels faster nowadays.9 This can distort people’s perceptions even when economic fundamentals seem solid. So, a deadly virus, racial tensions, and wars are enough to create a cauldron of negativity even when the economy is growing, and unemployment is low. Worse, reporting of economic news has also turned more negative since 2018 with the trend intensifying over the last three years, according to a study by Brookings.10 In such an environment, any new bad news—however, minor that is—may create even more negativity.11
It is unwise to use consumer sentiment in isolation
Studies show that measures of consumer sentiment offer a helping hand in drawing conclusions about the outlook of economic activity when no other indicators are available.12 But, given the wide availability of data in the economy, it would be prudent not to place too much emphasis on the CCI and the ICS to gauge economic conditions and predict the future—more so in the age of social media and negative news flows. Economists and businesses, therefore, need to be careful in drawing conclusions about economic and consumer outlook by looking at measures of consumers sentiment alone. Not only should they understand the factors impacting these sentiment indicators but gauge a multitude of data to make sense of trends in consumer spending and wider economic activity.