Amid a recovery, consumers face off against inflation

Consumers have been at the forefront of the postpandemic recovery, with real consumer spending growing by 12.1% in 2021.¹ Sustaining this recovery in the medium term, therefore, depends much on their ability and willingness to raise their purchase volumes. So, it’s worrying to see different moods in two key measures of consumer sentiment. As figure 1 shows, the University of Michigan’s Index of Consumer Sentiment Index (ICS) has been trending much lower than the Conference Board’s Consumer Confidence Index (CCI) since early 2021. That’s unprecedented as the two measures have never given such different signals. Does that mean we don’t really know the pulse of US consumers? Thankfully, that’s not the case. The gap between the two measures is mostly due to inflation and its greater role in the ICS than in the CCI. This leads to a more important question: Does high inflation threaten growth in real consumer spending? The answer is yes. Rising inflation weighs on consumers’ purchasing power by slowing or even reversing gains in real wages and wealth. It often forces households—especially low- and medium-income ones—to pull back on discretionary spending. Worse, any higher-than-expected rise in inflation may force a stronger dose of monetary tightening, further weakening the impetus for consumers to spend. Inflation also hurts low-income households more than others, thereby widening income inequality.

Rising inflation poses risks for real consumer spending

High inflation and improving labor market conditions are opposing forces influencing real consumer spending. While strong job creation and declining unemployment have aided income growth, and hence spending, rising inflation can dent consumers’ momentum through three key effects.

First, inflation has affected growth in real income, thereby curtailing consumers’ purchasing power. While nominal earnings continue to rise due to labor market tightening, real earnings have been on a broad downward trend since last year (figure 4). Since January 2021, as inflation has gone up, real average weekly earnings have fallen 4.5%, even while nominal earnings rose 4.8% in this period. No wonder then, that, consumers appear worried about their finances despite strong job growth. Deloitte’s survey of consumers reveals that as COVID-19 infection cases recede, concerns about personal finances are rising.² In March, 54% of respondents expressed concern about the amount of money they were saving; this share has been rising since June 2021 (figure 5). It’s not just income that inflation dents but also gains in real wealth, which, in turn, has the potential to weaken the positive “wealth effect” on consumer spending. Real net worth³ of households in the United States grew 9.5% last year, slower than the 14.6% gain in nominal net worth. This differential will continue to widen if inflation remains high.

Second, as inflation percolates down to specific spending categories, consumers will increasingly substitute some items for cheaper ones, while reining in spending on discretionary items. Since essential items such as groceries are more difficult to substitute and with the prices of even cheaper substitutes going up, consumers—especially low-income ones—will need to cut other types of purchases. According to Deloitte’s survey of consumers, three in four Americans in March cited higher prices for groceries compared to the month before; the figure has gone up over the past six months (figure 6). Rising nominal value of purchases will weigh on personal savings and stretch credit card debt. The personal saving rate (6.3% in March) is now below prepandemic levels and worries about credit card debt, as figure 5 shows, have been rising steadily since the middle of last year.

Third, if high inflation persists, monetary tightening may turn out to be more than expected. This will impact credit growth and cost of borrowing. Those with high levels of credit card debt already paying high interest rates have much to worry as those rates are generally tied to the prime rate, which moves with the federal funds rate. Mortgage rates have also been rising since the beginning of 2021, with the 30-year mortgage rate reaching 4.95% by April 1.⁴ That is much higher than rates in February 2020 (monthly average of 3.66%), just before the pandemic started. Rising mortgage rates also come at a time of sharp rise in home prices. According to the Federal Housing Finance Agency house price index, home prices grew 18.2% year over year in January; price growth has been in double digits since October 2020.⁵ The twin effects of rising home prices and higher mortgage rates may turn off potential buyers and soften the housing market, which will then weigh on the value of housing in household balance sheets. More than others, households at the lower half of the wealth ladder are likely to be impacted by any housing slowdown as real estate has a larger share in their total assets. Real estate accounted for 53.4% of total assets held by households in the bottom half of wealth distribution, much higher than the shares for the 11–50 percentile cohort (34.6%) and the 2–10 percentile one (20.5%).⁶

With inflation high, consumers also face widening inequality

While rising inflation poses risks to real consumer spending and hence, economic growth, its potential impact on income inequality is also worrying.

• Low-income households spend more on necessities such as groceries, energy, and housing than higher-income ones. Estimates quoted by Fed officials suggest that lower-income households spend about 77% of their budgets on necessities, compared to just 31% for higher-income households.⁷ Poorer families are therefore likely to feel the pinch of surging food and energy prices more, especially with food inflation at 8.8%—the highest since the stagflation years—and energy inflation at 32% in March.
• Low-income households will likely find it harder to substitute products whose prices are rising than others. These households may already be purchasing low-cost versions of a product given their limited budgets and hence, there may not be a cheaper variant available to buy during times of prices rises—either they end up paying more for the product or must forego it altogether.⁸
• Studies also reveal that low-income households, on average, depend more on wages and government transfers for their income, compared to households with higher incomes who also benefit from their investment earnings.⁹ While inflation dents real wages, as is evident from figure 4, investment income generally tends to be less affected.¹⁰ For low-income households, high inflation also comes at a time when pandemic-related transfers have been gradually phased out.

A surge in optimism may have to wait a bit

For consumers, inflation often leads to a wait-and-watch game as they adjust to rising prices and wait out the near-term impact of counter-inflationary policy on the economy. This year, that wait may turn out to be a tad longer. Oil prices, already rising in 2021, got a new boost due to the conflict in Ukraine. Producers struggling with rising input costs will now find it even more difficult not to pass on a part of that cost to consumers. And added to that, there may be more disruptions in global supply chains owing to COVID-19–related lockdowns and mobility restrictions such as the recent ones in Shenzhen and Shanghai in China.¹¹

Unfortunately, it takes time for hostilities to end and businesses to clear backlogs. Until such time, US consumers will continue to feel the pinch of inflation.