By Patrick Hill
“How are you feeling?” That’s often the way we greet people these days. As the Omicron variant becomes widespread, negatively impacting most Americans’ lives. Add worries about inflation to the mix. Finally, some schools are going back to online learning, forcing parents to work from home with kids at home. Consumers are stressed, anxious, and uncertain about the future. If the drop in consumer sentiment continues, retail sales will fall.
Consumer spending is 70% of GDP. Thus, if consumer spending continues to decline, a recession becomes more likely. The Federal Reserve plan to speed up monetary tapering and start interest rate increases will add momentum to a decline in economic activity. Rising costs of credit cards, mortgages, and personal loans will trigger a drop in consumers applying for new loans. As credit tightens, consumers will pull back on spending. Let’s look at trends in consumer sentiment, spending, and inflation to see why economic headwinds are building.
Consumer Sentiment Falls Along with Retail Sales
A significant drop in consumer sentiment reflects the consumer’s plight. The University of Michigan January consumer sentiment indicator printed 68.8%. The drop is the second-largest drop in ten years. The survey found the number one consumer issue was surging inflation. A third of consumers felt they were financially worse off than a year ago, near the same level as April 2020.
Sources: University of Michigan, Bloomberg – 1/15/22
Consumers’ unease with their financial condition was recently expressed in a substantial decline in retail sales for December of 1.9%. Buyers before the Omicron variant started buying from pent-up demand for goods in particular. That pent-up demand buying seems to be waning.
Sources: Commerce Department, New York Times – 1/15/22
Twenty-five percent of respondents said their reduction in spending was due to inflation.
Also, retail sales fell fast due to buyer concerns about leaving home. Consumer mobility indicated by Google mobility indicators shows a drop off in outside of the home trips. Plus, the Langer Buying Climate index declined as consumers continued to see the present buying environment worsen due to both Omicron infection risk and inflation. A double whammy for retail sales. While spring may bring a decline in Omicron virus infections, inflation is likely to persist.
The Langer Index posted its most significant one-week drop in 36 years! The critical component causing the considerable drop was consumer concerns about this being a ‘good time to buy things,’ showing a 6.9% decline. The component drop was the largest since 1985.
Will Inflation Persist Driving Consumer Sentiment Lower?
Yes. This is the short answer from a macro perspective. The Federal Reserve has increased the money supply significantly above the pre-pandemic trajectory as the following chart shows a surge in the M2 money supply. The second chart shows a lag of 2 to 3 years in inflation after shifts in the money supply. So, on a macro basis, inflation is likely to be a continuing issue.
Sources: St. Louis Federal Reserve, The Daily Shot – 1/12/22
Sources: Labor Department, Haver Analytics, The Daily Shot – 1/7/22
Several components are likely to keep inflation high even as waning demand in other sectors may decrease inflation. A significant persistent inflation sector is housing.
Housing Costs Fuel Inflation
Housing is the most expensive cost for most families. An increase in shelter costs hits family budgets hard. As millions of workers were forced to work from home during the pandemic, the demand for housing outside major core cities soared. Owner equivalent rent (OER) is how the Bureau of Labor Statistics computes home costs to compare to rent. Note the surge in OER and rent for 2021 and the Nomura forecast for 2022.
Source: Apartment List, Bureau of Labor Statistics, Nomura, The Daily Shot – 1/14/22
Along with housing inflation, price increases are becoming embedded in the broad-based economy.
Inflation Becoming Embedded into the Economy
The headline Consumer Price Index (CPI) posted a 7.0% increase for December 2021. A 20 year high. Consumers feel the price pinch in the cost of gas, food, new and used vehicles, and furniture. The following heat map shows how inflation is increasing across multiple sectors of the economy.
Sources: Bureau of Labor Statistics, The Daily Shot – 1/13/22
The components of most concern to consumers: housing, food, and energy, are excluded or minimized in key indicators that the Federal Reserve uses to measure inflation like the Core CPI or Trimmed CPI. This lack of focus on what is essential to consumers and affecting their buying habits is a significant policy-making blind spot. As such the focus on lower inflation figures caused the Fed to underestimate inflation related to buying power. As a result, the Fed must slam on interest rate brakes to grab executive and consumer attention that they are serious about controlling inflation.
Consumer buying power is declining as well due to negative real wage growth.
Real Wage Growth is Negative
Consumers are rightly worried about their financial future. Worker real wage growth is negative. Real wage growth accounting for inflation was – 1.5% for December. The following chart from BOC Research shows using Federal Reserve data that inflation is ‘eating into’ wages in the U.S.
Sources: BOC Research, Federal Reserve of Atlanta, The Daily Shot – 1/7/22
Consumers see high prices and look at their paychecks, concluding they are not keeping up with costs. They are right. Consumer perception of inflation limiting their buying power drives reluctance to spend. Buyer frustration with high prices is a critical factor in the December 24.6% drop in vehicle sales. Also, rent prices are beginning to decline in many major U.S. markets, as renters decide to stay in their present apartment.
Will Inflation Go Back to Pre-Pandemic Levels?
Not likely. A new trend is emerging globally, affecting inflation that may persist for many years – green inflation. The ability of the energy sector to create new renewable sources of power while continuing to supply the needs of world energy users is tight. Not enough investment in green technologies is happening, according to Isabel Schnabel, executive board member at the European Central Bank. In a recent Bloomberg interview, she further stated that fossil fuel prices might stay elevated to make green investments possible. Plus, higher fossil fuel prices will force corporations and consumers to shift to renewable sources quicker.
As fuel costs feed into the cost of transporting goods, inflation may stay elevated for some time. Further, other transportation issues cause concern about inflation. Shipping unloading bottlenecks continue at West Coast ports, causing a container’s cost to rise incredibly from $1,400 in February 2020 from Shanghai to Los Angeles to $10,200 in December. As demand falls, the number of containers to be unloaded will fall, but it takes a long time to solve the bottleneck problem as trucking companies can’t hire enough drivers.
Fed Liquidity Tightening, Consumer Spending Decline Increases Chances of Recession
The latest Fed Funds futures report shows growing investor sentiment that rate increases could begin as soon as March of this year. The recent Federal Reserve FOMC meeting minutes spooked the markets when it became apparent that the Fed was turning more serious about persistent inflation. Forecasters expect at least three rate increases this year, maybe four. So, a liquidity crunch will start sooner and faster than investors had expected just two months ago.
The decline in consumer sentiment, we have noted in this post, will drive a drop in consumer spending. The combination of liquidity tightening with a fall in consumer spending will create downward momentum in economic activity. As a result, a decline in economic activity will result in a recession.
Mitigating the possibility of a recession is the surge in hiring and construction from the $1.8B infrastructure spending bill approved by Congress. Another factor is the waning of Omicron in the spring, so mobility and retail sales move up.
But the Fed is in a difficult position as the economy seems to be slowing due to inflation, the Omicron virus continuing to spread, and supply bottlenecks. Mohamed El-Erian, Chief Economist at Allianz, offers this observation on the impact of inflation on consumers and their sense of financial insecurity in a January 12th tweet:
“Inflation isn’t just a number to be managed by the Fed that few Americans know well. It also influences economic, social, and political outcomes. When its high, as it is today, it fuels financial insecurity among the most vulnerable, both immediately and over time.”