Focus
July 22, 2022 | 13:45
How Long Can U.S. Consumers Hold On?
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
How Long Can U.S. Consumers Hold On? |
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Headline U.S. retail sales and food services rose a sturdy 1.0% in June, but with prices increasing at a comparable pace, real retail sales were likely little changed. Indeed, we expect broader personal consumption expenditures (PCE), after adjusting for inflation, will be flat in June, capping a quarter in which real PCE should expand at a 1.0% annualized rate. This will be the weakest quarterly result since the pandemic recession and, before then, since the early stages of the recovery from the Great Recession. And, there’s probably more weakening in store. The combination of high inflation, rising interest rates, weakening financial conditions and eroding confidence is weighing heavy on spending. However, there are some offsetting factors with the potential to keep real consumer spending growth in positive territory for a while longer. High inflation |
As mentioned above, the CPI increased 1.3% in June to register a fresh 40-year of 9.1% y/y. Meanwhile, the PCE price index, more representative of current consumer spending patterns, was up 6.3% in May. Although down from March’s four-decade high of 6.6%, we reckon June will jump to reach a new peak. We don’t expect these inflation rates will change much by year-end, remaining within ±1 ppts around the latest readings. The resulting erosion of purchasing power should contribute to the continued weakening of real spending, particularly for households with less flexible budgets. However, there are two counterweights to the drag from inflation: wage growth and the ability to tap excess savings. The major wage metrics such as average hourly earnings (for production and nonsupervisory employees), the Employment Cost Index (covering private sector wages and salaries) and the Atlanta’s Fed’s Wage Growth Tracker are all expanding at their fastest rates since the early 1980s, allowing for the technical whipsawing of average earnings during the pandemic (Chart 1). Hovering in the 5%-to-7% range, such wage growth can offset much of the impact of inflation rates running around 6%-to-9%. Meanwhile, households accumulated a massive cache of excess savings during the pandemic, which they’ve only started tapping on a sustained basis in January (Chart 2). Before the pandemic, consumers were saving 7.5% of their after-tax incomes. Using this as the standard, between March 2020 and December 2021, as the saving rate initially spiked above 33% and averaged above 12% last year, $2.5 trillion of excess savings were amassed. Since the start of the year, this has been drawn down by $155 billion, as the saving rate has been hovering in the 5% range. These drawdowns helped cover the additional cost of consumption (think of them as income supplements). |
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There’s an adage about the cure for higher prices being higher prices, reflecting the disinflationary (or deflationary) impact of purchasing power erosion as less real spending creates economic slack, as more supply is encouraged. However, if compensating wage gains (think wage-price spiral) or tapping excess savings dull the cure on the demand side, then this likely leads the Fed to tighten more aggressively than it otherwise would in fighting inflation. Rising interest ratesThe Fed has already lifted policy rates by 150 bp since mid-March, with a second consecutive 75 bp hike likely on July 27 and forward guidance about “ongoing increases in the target range will be appropriate” probably repeated. Meanwhile, quantitative tightening (QT) started June 1 and the non-reinvestment caps of $30 billion for Treasuries and $17.5 billion for MBS will be doubled on September 1. These policy efforts have cast their influence along the Treasury yield curve and over the mortgage market. Consumer borrowing costs have gone up and will likely increase further; we’re expecting an additional 125 bps of Fed rate hikes by year-end alongside QT. Rising interest rates are already impacting credit-based consumer spending and should continue doing do. Though supply constraints persist, the annual trend in light-weight vehicle sales slipped under 13.5 million in June, the lowest in a decade. Home sales have fallen for the past five consecutive months, pulling down real spending on often-associated goods and services (such as furniture and appliances). Meanwhile, by increasing the cost of existing debt such as adjustable rate mortgages and other variable rate loans, rising interest rates impact spending broadly by absorbing a bigger share of household budgets. |
Total household debt hit a record-high $15.8 trillion in Q1, posting the strongest annual growth (8.2% y/y) in 14 years (Chart 3). This was led by mortgages reflecting the booming housing market (until recently) and record-high home price appreciation (that continues). Such record high and rapidly-growing debt suggests spending could be more sensitive to rising interest rates. However, debt has remained stable relative to after-tax income. Looking past the whipsawing of personal income during the pandemic, the current debt ratio of 87.1% is in line with readings during the latter half of the last decade (and miles below the 2008 peak). Meanwhile, the debt service ratio is still the lowest it has ever been compared to the period before the pandemic. Indeed, consumers had some capacity to absorb higher interest rates and payments, which has since come in handy. |
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Weakening financial conditions |
Apart from higher interest rates (lower bond prices), the Fed’s tightening actions are intended to impact the economy by weakening financial conditions broadly, such as by contributing to lower equity prices and wider credit spreads (and, yes, cheaper crypto currencies). Weakening financial conditions weigh on consumer spending by creating a negative financial wealth effect. However, some of this decrease in financial wealth is currently being offset by increases in nonfinancial wealth or real estate. For example, household sector net worth fell by $544 billion in Q1 (Chart 4), reflecting a $3.0 trillion drop in the value of equity holdings, despite $74 billion in net new purchases during the period, as prices dropped by 5.9% (Wilshire 5000). Meanwhile, there was a $1.4 trillion increase in home equity, as home price popped a record high 5.9% (S&P CoreLogic Case-Shiller Home Price Index). |
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The marginal propensity to consume out of wealth is typically estimated at around 5%. So, a $544 billion drop in net worth could pull down consumer spending by $27 billion or $109 billion at an annual rate, over time. To put this into context, nominal consumer spending increased by $356 billion or 9.0% annualized in Q1 to $16.7 trillion. But after adjusting for inflation, real PCE expanded only 1.8%. Interestingly, for Q2, while home equity likely increased by another $1 trillion-plus (for the sixth consecutive quarter), stock prices alone dropped a further 17.6% causing an $8.1 trillion financial wealth headwind on top of the ones caused by rising yields and widening credit spreads over the period. |
Looking ahead, apart from the above sizable wealth reduction weighing on nominal and real PCE owing to lags, there’s more Fed tightening still to come with the potential for even more weakening of financial conditions. And, we reckon it’s only a matter of time before home prices finally slip at least a bit. Eroding confidenceAgainst the background of rising prices, particularly for gas and groceries, rising Fed policy rates and related recession anxiety, along with sagging financial markets, consumer confidence has fallen sharply (Chart 5). The plummet in the University of Michigan metric to its lowest level in history was shocking. Looking back to 1952 (when the data started) there has been a glut of confidence shattering events. Those associated with recessions include the pandemic, global financial crisis, tech wreck, savings and loan crisis, Paul Volcker’s Saturday Night Special (record rate hikes) and an OPEC oil embargo. Yet the current situation is deemed the most confidence shattering, which does not bold well for consumer spending, particularly on big ticket items. However, part of this was probably a knee-jerk reaction to surging gas prices and plummeting equity prices. Besides, the Conference Board’s metric, which is more influenced by labour market conditions than the University of Michigan measure, has not declined as steeply. It remains well above its past recession readings. The ‘truth’, as far as confidence is concerned, is likely somewhere around the middle. Nevertheless, short of a major and lasting reversal in food and energy prices, we reckon the falloff in consumer conference will weaken spending further. Bottom Line: The headwinds and tailwinds acting on real PCE growth appear to be pointing to a potential net contraction. Since the mid-1950s and over the past 10 cycles, whenever PCE has contracted, the economy has been in a recession, or was about to enter one, or had recently exited one (Chart 6, post 2019 not shown). A much larger spending lift from excess savings and more resilient employment conditions could prevent history from repeating itself. |
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