What explains the staying power of the consumer?

Summary

Making your way in the world today takes everything you’ve got. Inflation is about as high as it has been any time since Cheers first aired on TV in 1982. Roughly 40 years on, however, inflation is one of the few factors influencing consumer spending that looks the same as it did then. This cycle has been unusual in that the recession improved rather than damaged household balance sheets. This report examines how this afforded households the wherewithal to sustain and even increase spending despite rapidly rising costs, and it clarifies why we suspect it cannot last.

• Persistent and broad increases in prices are undoubtedly the biggest headwind for consumers today as price gains erode gains in income.

• But this cycle has been unusual in that the recession improved rather than damaged household balance sheets.

• This is largely due to the ample amount of fiscal support infused into the household sector when many were unable to consume at normal levels, as well as the relatively steady rise in asset values through the end of last year.

• In short, this means households do not need to deleverage today and are actually able to rely on their balance sheets in the near term to fund spending.

• Households are able to meet monthly payments by saving less, by drawing down a massive stockpile of excess savings or by accessing credit. We see a combination of the three as plausible.

• Consumers have been taking a break from all their worries and that sure has helped prop up spending in the face of higher inflation. But sustaining spending becomes more challenging the longer inflation persists and as monetary policy becomes more restrictive.

• Our base case is that consumer spending will downshift over the next several quarters particularly as rate hikes begin to ratchet up the cost of credit. Even though we expect consumer spending to remain below trend throughout the forecast period, we do not look for sustained declines in outlays.

• We note, however, even if households get spooked and spending slows more in the near term than we expect, healthy balance sheets and manageable debt loads should prevent a downturn from being severe.

Gravity is working against me

While there are many challenges for the consumer, persistent and broad increases in prices are undoubtedly the biggest headwind. Consumers are not helpless in the fight against higher prices; a tight labor market continues to lift wages and salaries. That has supported overall income growth even as fiscal support has ceased, but inflation has largely eroded those gains. Real disposable income growth has trended lower over the past eight months. Using the trend growth of the prior cycle as a guide, disposable income currently sits about 4% below where it would be in the absence of the pandemic on an inflation-adjusted basis (Figure 1).

When prices are rising faster than incomes, that should mean a hit to household’s ability to consume. There is plenty of evidence that people are feeling the squeeze; consumer sentiment has fallen to a decade low and an increasing number of Americans report difficulty paying their bills.1 Some households are no doubt having to make difficult choices about spending, but so far, overall personal spending remains remarkably—even confoundingly—intact.

Personal consumption expenditures rose at an above-trend 2.7% annualized pace in the first quarter, and even once adjusted for inflation, we estimate real retail sales rose about 1.2% in April, leaving the level of sales nearly 10% above its pre-pandemic position despite raging inflation (Figure 2). With inflation eroding income and driving up the cost of many goods and services, why aren’t households spending less?

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