Don’t Listen to What They Say, Watch What They Do: The Impact of Inflation on U.S. Consumers

Side effects of COVID-19 may include high inflation 

Following the initial COVID-19 downturn, there were severe disruptions on both the supply and demand sides that caused inflation to ramp up sharply. The nature of the pandemic forced factories around the world to shut down essentially overnight, bringing global production and trade to a halt in 2020. Even as manufacturing plants reopened, goods production only increased intermittently due to the virus’s erratic trajectory and subsequent business restrictions, rendering supply chains unpredictable and disjointed.  

On the demand side, fiscal stimulus and income-support measures introduced by the federal government resulted in a boom in household income, despite a brief recession. Even though studies show that most stimulus recipients saved the money or used it to pay down debt², there was still plenty of disposable income to support a mini-boom in consumer spending in the spring of 2021. Not only did households see a massive influx of cash, they simultaneously shifted the composition of spending dramatically curtailing travel and entertainment and stocking up on essentials and home goods. The share of U.S. consumer spending on goods, as opposed to services, jumped from 35% at the end of 2019 to 41% by mid-2021 (see chart above: Real Consumer Goods Spending). The coinciding surge in e-commerce further stressed retail logistics.  

Faith in the Fed 

We estimate that nearly two-thirds of the currently observed inflation is tied specifically to disruptions caused by the pandemic, the reopening process and energy. By that logic, inflation should gradually subside along with the virus’s influence:  a consensus panel of economists expect annual growth in the CPI to decelerate from 6.7% in 2021 to 3.6% by the final quarter of this year and to 2.4% in 2023 Q4.³ That said, many economists also expected that inflation would be subsiding by now — but it may not have even peaked yet (see chart below: CPI Inflation Parsed). Recently, the risk of higher-for-longer inflation has increased due to Russia’s invasion of Ukraine. As of March 2, the price of Brent crude oil closed above $114/barrel for the first time since 2014, which means consumers may soon see even higher gas and utility prices that are already elevated, although the risks of this are most acute in Europe. Energy markets are inherently volatile and are prone to self-correct; we should not expect oil and gas prices to spiral upward unabated. But until energy prices settle, consumers are likely to see prices at the pump get worse before they get better.  

It is far from certain that inflation will totally subside on its own, which is why the Federal Reserve’s Federal Open Market Committee (FOMC) is expected to step in and nudge it in the right direction by raising interest rates imminently. The idea is that higher interest rates raise borrowing costs throughout the financial system, tempering economic growth and giving supply chains a chance to normalize.  

This is not to say demand will decline abruptly or uniformly. Even after accounting for expectations of higher interest rates and elevated inflation, consumer spending is expected to grow by 3.9% in 2022 under our baseline forecast. Barring last year’s growth of 7.9% — when the economy was clawing out of a severe downturn — this increase would be the strongest since 2000. Spending in sectors that rely on financing — such as motor vehicles, homebuying and appliances — is likely to decelerate more than in service sectors, which were already poised for an accelerating recovery as the pandemic effects recede. Better balance in the composition of consumer spending will further help inflation normalize.  

There is no guarantee this plan will go smoothly, as the Fed’s dual mandates to keep the economy at 2% inflation and full employment are sometimes at odds. The Fed has had difficulty with this balancing act in the past, at times falling behind the inflationary curve and hitting the brakes too abruptly and tipping the economy into a recession. This is a low-likelihood scenario and one that would take more than a year to materialize; the current odds of a U.S. recession occurring in 2022 are only about 10%.  

Consumers sound nervous, but are they bluffing? 

Consumers have responded in an emphatically negative manner to price hikes across several surveys of consumer sentiment, yet actual spending has not missed a beat. Holiday retail sales in 2021 were the strongest on record and retail sales jumped even higher in January, even while inflation hit a 40-year high and while Omicron was spreading rampantly. Even more compelling is that spending was strong in discretionary retail categories such as department stores, apparel, furniture and electronics. This would not be the case if consumers were overwhelmingly concerned about inflation eroding their finances over the longer term. Indeed, consumer expectations for prices over the next 5-10 years are much more subdued than the outlook for one year ahead. These survey reactions may be equally reflective of political tensions, gas prices and COVID-19 fatigue (see chart above: Consumer Sentiment and Gas Prices). In terms of the spending outlook, it is important to watch what consumers do with their money, not just what they say. Right now, their pocketbooks say it is a good time for retail therapy. 

Current inflation should not be dismissed: it is a real concern. But it would take a confluence of several other risk factors to offset the host of favorable fundamental drivers currently at play. Between rising incomes, excess savings, higher asset prices, prevalent job openings and ample credit availability, households have enough confidence and wherewithal to maintain an above-trend level of spending for the next couple of years.  

Most crucial for the outlook is that the labor market continues to heal. Job and wage growth are the most enduring drivers of spending, and right now both are on fire. Amid labor shortages across many industries, we have seen a record number of people quitting jobs due to a general optimism about finding higher-paying jobs with better benefits. As a result, annual wage growth of 4.5% as measured by the Employment Cost Index (ECI) is the highest it has been in more than 20 years. While this is not enough to keep up with the current rate of inflation, this relationship is expected to reverse later this year, which will allow most Americans to enjoy “real” wage growth. Lower-income occupations are seeing even faster wage growth currently — a key factor as lower-income households are more sensitive to rising costs of essential goods such as food, gas and rent. Households may become slightly more cautious until price increases stabilize, but this was bound to happen as stimulus money is no longer a primary support. One thing we have learned from the pandemic is that U.S. consumers are a resilient bunch and are savvier than ever.  

Retail leasing: No stopping now 

Given the broadly favorable consumer environment, it is a good bet that retail leasing demand will build on a strong finish last year in 2022. Retailers expect this, as the number of planned store openings this year outpaces the number of planned closings. Encouragingly, store openings are aligned in segments that are more insulated from inflation. Dollar stores, discount apparel and quick-service restaurants are among the leading retail categories expanding their physical footprints — and those are the retailers that attract thrifty shoppers during times of rising prices.  

At the other end of the pricing spectrum, luxury retailers are finally poised for a breakout year thanks to the return of international travel and a post-pandemic urban revival. Luxury clientele are less price sensitive, so higher inflation is less of a deterrent, especially given that the wealthiest households have accumulated the most excess savings during the past two years.   

If inflation proves to be stubbornly high for an extended period, it may deter spending at mid-priced apparel brands, department stores, and fine dining restaurants as consumers are forced to spend more on necessities and discount items. That said, we have yet to see material evidence of this, and the opposing force of pent-up demand may be strong enough to outweigh price concerns. Consumers are eager to get back into the shops and restaurants that were off limits for so long.   

¹ Source: Moody’s Analytics
² https://www.dallasfed.org/research/economics/2022/0111
³ Source: National Association of Business Economics (February 2022 Outlook Survey). Note that these figures are Q4 versus prior year Q4 growth rates. In 2021 Q4, YoY growth was 6.7% for the quarter (versus 7.5% for the month of January 2022).