Transitory or not, inflation is coming for the consumer

Summary

Last week's University of Michigan consumer survey reported that sentiment fell to its lowest level since February. A key factor in the wilting confidence was inflation worries, which by some measures are ashing red in a way they have not in a generation. Massive cash savings, faster income growth, and generous tax credits will mitigate some of the price gains, even as all that liquidity makes the price problem worse. It is increasingly evident that inflation rules all facets of the economy at present. Our real personal consumption expenditures (PCE) outlook will have inflation headwinds to overcome in the second half. We presently have 8.6% PCE growth penciled in for the third quarter and 7.5%for Q4; because of inflation's toll, we now see downside risk to these numbers.

Soaring inflation is weighing on sentiment

When it comes to the post-pandemic economic reopening, a case could be made that consumer sentiment got ahead of reality. The University of Michigan's Survey of Consumer Sentiment tumbled in July to 80.8, its lowest level since February, and a sharp decline from the 85.5 level the month prior. The report was published just 90 minutes after the Commerce Department data for June showed that retail spending was more robust than most forecasters expected. What's happened to the mojo of the American consumer?

Broadly, we think that the lifting of the mask mandates was perceived by many consumers as the end of COVID and the promise of better days. The reality is proving to be a lot more complicated. Yes, life is returning to a version of normal, but surging demand against a backdrop of scarce resources and a lack of skilled labor in some industries has ushered in a degree of inflation that many younger consumers have never experienced.

Last week, we learned the CPI for June came in at 5.4% on a year-ago basis. Only one month in the past30 years has CPI inflation been higher. While it is true that the year-ago figures are coming o a low starting point, it is more than just base effects. The monthly increase of 0.9% was the third-highest in 30 years. Transitory or not, this is the highest inflation any consumer has experienced in about a generation, and it is clearly taking a toll on consumer sentiment.

To quote from the University of Michigan survey's accompanying press release, "References to high prices of homes, vehicles and household durables rose to the highest level in a half-century.” A bit of inflation can be a good catalyst to get a consumer o the fence on a potential purchase, but when prices rise this fast it can have the opposite effect as unfavorable perceptions about prices just sap the will to buy altogether. That appears to be the case in last week's report with buying intentions for autos and homes falling to their lowest levels in almost 40 years (since 1982).

A bigger burden than we appreciated

Candidly, the wilting in confidence took us off guard a bit. We are aware of the price dynamics; we have one of the highest forecasts for CPI inflation on the Street. But when it comes to the consumer, our view has been that after more than a year of being couped up indoors, households would be prepared to pay any price within reason to get out and enjoy life again. We have also maintained that the accumulated cash savings that households have accrued will help absorb some of these higher prices. We still think that is true. Note, for example, that household nances versus a year ago were unchanged in the month and that the share of consumers expecting a higher income rose to 53.3%from 52.8% previously. BUT, there was a ve-point drop in the share of households that expect their income gains to keep pace with inflation.

Still, the message that confidence can be shaken by higher prices may serve as a wake-up call that inflation poses a tangible threat to a consumer-driven post-pandemic recovery. There are some silver linings to keep in mind. Many households will begin receiving child care tax credits this month, and that may result in an upward revision to the final release for July consumer sentiment at the end of next week. Also, some of the inflation dynamics are indeed transitory; when motor vehicle assemblies pick back up, the bottom will likely fall out beneath used car prices. After making headlines just a few months ago, lumber prices are down more than 60% since May and are generally lower now than at the start of the year.

Buying attitudes show signs of sticker shock

Whether or not inflation is here to stay, it is clear in the short term that rising prices have curbed consumers' appetite for new purchases and could provide a headwind for spending. Three buying options are covered by the University of Michigan's survey: homes, vehicles, and large household appliances. All of these categories have seen buying conditions slide over the past couple of months. Vehicles and large household appliances have seen attitudes drop in ve of the seven months of this year, and views of home-buying conditions fell in six out of seven. These declines have lowered buyingattitudes for homes and vehicles to their lowest point since 1982. Price is unequivocally the culprit for declining interest in new purchases. The proportion of consumers citing "high prices" as the reason it is a bad time to buy has jumped to the highest since 1978, the series starts, for homes and vehicles and is the highest since 1980 for large household goods.

As we mentioned in our recent retail sales report, our call for a 12.9% increase in spending in Q2 is for real personal consumption expenditures, so inflation presents a risk if some of the nominal spending increases we are seeing translate to not-so-impressive real increases after price adjustments. This is the technical way in which inflation could negatively affect real spending. However, sticker shock is the second, more psychological of the two-pronged threat inflation poses to spending, and these survey responses show evidence that higher prices may have started to affect consumers. It is worth noting that this comes from survey data, and what consumers say they would do versus what they actually do is not always in sync. We have all experienced a time or two when we paid for something knowing that it was overpriced. After a year plus of being couped up, to what extent will consumers adopt that mindset? Our best sense is that they will be price takers during the initial rush this summer, but come autumn, we will likely see increased price sensitivity. We presently have 8.6% PCE growth penciled in for the third quarter and 7.5% for Q4; because of inflation's toll, we now see downside risk to these numbers.

In addition, these measures capture durables, home, and auto purchases, which are not part of the services spending that we see driving this year's boom and for which consumers may be willing to overpay since many activities were o-limits. For what we otherwise expect to be a solid year for the consumer, the key risk in our view is that price worries suggested by the survey data start to make their way into actual spending behavior.

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