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Market-Based Solutions to Vital Economic Issues
Kenan Insight
May 28, 2024

Convening the Experts: Consumer Sentiment vs. Economic Indicators

The U.S. economy, by many measures, is a model of strength and resiliency. According to the Bureau of Economic Analysis, U.S. real GDP grew by 2.5% in 2023, far outpacing its G7 peers, and the Bureau of Labor Statistics reports that unemployment has remained below 4% for more than two years, the longest such stretch in half a century. Inflation, which ballooned to 7% during the COVID-19 pandemic, has come down from its peak in 2022, and is now 3.5% in the year ending March 2024, according to the BLS’ consumer price index. Inflation-adjusted median household income shrank in 2022, yet incomes have risen faster than inflation for the past 18 months.

Real Gross Domestic Product

Misery Index
(Unemployment + Core PCE Inflation)

These core economic metrics paint a somewhat rosy picture of an American economy emerging from the calamitous pandemic years stronger than its peers. Yet, when asked about the nation’s economic outlook, Americans seem a bit glum. Consumer sentiment has risen markedly from its mid-2022 low, according to the University of Michigan’s Consumer Sentiment Index, yet the vibes are not as bright as one would expect given the moment’s upbeat statistics. The so-called misery index, which sums unemployment and inflation rates, stands around 7%; historically, this low level of misery would correspond to a Consumer Sentiment Index value north of 90, according to TD Economics.1 In May of this year, U-M's consumer index was at 69.

What gives? Why are Americans – usually known for their economic optimism – so pessimistic?

We asked four Kenan Institute experts to give their perspectives on the disconnect between consumer sentiment and data-driven economic indicators, and their insights point to underlying sources of economic unease for Americans.

Drawing from your expertise in neuroeconomics, how would you explain the phenomenon we’re observing in which consumer sentiment is gloomier than the economic data would suggest?

Camelia Kuhnen: I challenge the premise – that consumer sentiment is especially gloomy – because I think the data is telling a more nuanced story than this. There are two widely accepted surveys reporting U.S. consumer sentiment: the University of Michigan’s and The Conference Board’s. U-M’s survey shows consumer confidence rising markedly from a low in 2022, while The Conference Board’s results are a bit more puzzling, showing that consumers feel pretty good about their current financial situation and present economic conditions, yet they are considerably less optimistic about the future. The two surveys have methodological differences that may explain their distinct trends, yet it is the divergence – people feel better about the economy today than they do about the economy six months from now – that is puzzling to me.

What does this discrepancy suggest about the public mind-set? The data from both surveys shows that consumers are not overly worried about inflation, yet there seems to be uncertainty about future growth, as most people do not expect recent gains in wages to continue at such a robust pace. The average American may not be preoccupied with current or future inflation, yet the trauma of the recent inflationary period is still felt. People see higher prices, and they realize that while their grocery bill may have stabilized, it won’t be coming down. In this way, inflation creates a sort of “sticker shock” that lasts longer than the period when prices are actually rising faster than wages.

Richard Curtin, University of Michigan economist and longtime director of the school’s consumer sentiment surveys, said two years ago that U.S. consumers were exhibiting “inflationary psychology” that would precipitate “a self-perpetuating wage-price spiral.” Curtin asserted that this spiral occurs when “consumers purposely advance their purchases … to beat anticipated future price increases. Firms readily pass along higher costs to consumers, including the future cost increases that they anticipate.”

Of course, the same month that Curtin made this ominous prediction – April 2022 – the Federal Reserve started aggressively raising interest rates, which has helped to bring inflation down, although not yet to its target level of 2%.

It seems we’ve averted – for now – the doom spiral that Curtin predicted. Yet to what degree do you think “inflationary psychology” has taken hold among American consumers?

Camelia Kuhnen: Despite the potential for the “sticker shock” that I described, I do not believe inflationary psychology has taken hold among Americans. The survey data clearly shows that consumer expectations for inflation are anchored around 3% over the next year and five-year period, and this is an entirely reasonable expectation. The U.S. Federal Reserve is quite hawkish about inflation, and I believe it will get inflation below 3%.

The near-term pessimism we’re seeing is, however, hard to square with robust consumer spending – if people are concerned about the future economy, shouldn’t they be saving more? Perhaps households are present-biased, and their spending reflects their current situation more than anticipated hardship or uncertainty. It is also possible that consumers have heightened uncertainty about the future because of recent adverse and tumultuous conditions, with some remembering the Great Recession of 2008-09 and then the extraordinary shock of the COVID-19 pandemic and its inflationary effects. In my research I have found that individuals who experience adversity and instability in their life tend to be more pessimistic and uncertain about the future. We may be seeing this psychological effect influencing consumer sentiment today, yet I want to emphasize that the survey data is largely showing reasonable public responses to recent and current economic conditions.

U-M’s consumer surveys and other studies have shown that political affiliation affects consumer sentiment. When a Democrat occupies the White House, Democratic Americans feel better about the economy, both now and in the future, and this political bias holds true for Republicans as well. U-M’s consumer surveys report that “partisan gaps are currently considerably larger than gaps by income, age, and education, suggesting that the way consumers interpret ongoing economic trends continues to be colored by partisan perspectives.”2

There are signs that the recent inflationary period has only widened the gap in consumer perceptions along party lines.

Drawing from your expertise on macroeconomic indicators and your experience working at the U.S. Department of the Treasury, to what degree is partisanship affecting consumer sentiment today? 

Gerald Cohen: There is clear evidence that partisanship has increased over the past several decades and that heightened political fervor is showing up in consumer sentiment surveys. The more that sentiment depends on the party in power, the lower the sentiment baseline. Politics, in other words, muddies the economic outlook, making the average American gloomier, at least in their survey responses, than they should be given present economic conditions. The recent inflationary period seems to have worsened this effect, perhaps because the Republican Party has historically had a more adverse view of inflation than their Democratic counterparts. A media environment that increasingly amplifies like voices may also share some blame for stoking political divisions, catastrophizing economic issues, and depressing public sentiment about future conditions.

Yet I want to underscore that partisanship is only one factor influencing the economic outlook, and that the recent inflationary period has had lasting effects. Most prices that go up do not come down, and these increases tend to be regressive, meaning that they hit low-income households the hardest, as individuals with less money spend a greater share of their income on necessities – mainly food and fuel – than do wealthier households. While grocery bills aren’t rising much now, they have risen 25% since 2020, and people readily recall the days of lower prices. Wages have grown slightly faster than prices, yet research has shown that individuals tend to believe that they are responsible for their wage increases while the prices of goods and services stem from macroeconomic conditions independent of how much they make.

What, if anything, can political leaders and public servants do to boost the mood as well as the economy?

Gerald Cohen: I think that it is time for a compassionate voice from government. Political leaders should speak directly to American consumers, acknowledging their pain – not only the difficulties associated with recent price increases, but also the pain coming from the bitter medicine of inflationary ills. Interest rate hikes also have distributional effects, as they raise the price of money, which may help savers, but it is a difficult pill to swallow for anyone looking to buy a home, a car or any other asset they would need to finance. By raising interest rates, the Federal Reserve is largely affecting the demand side of the inflation equation, whereas much of the inflationary shock brought on by the COVID-19 pandemic has stemmed from supply-side issues.

These issues require long-term thinking, policies and interventions from other branches and offices of government, along with coordinated campaigns informing consumers of what they stand to gain from public investment. Lasting solutions to the lion’s share of America’s high-price pain are in structural reforms that would change fundamental conditions in key economic sectors. Improving housing policy, for instance, so that more affordable homes are built, would bring down housing costs. Investing in public transit and efficient urban infrastructure would lower consumer exposure to the costs of transportation.

A group of prominent economists have argued in a recent working paper that the cost of money, i.e., high interest rates, explains much of the discrepancy we’re seeing between consumer sentiment and economic indicators. Since most price indices do not account for the cost of money, the authors argue, actual inflation is considerably higher than reported.

How much of the discrepancy between American household financial health and sentiment can be explained by measurement error? Are we simply not measuring price increases in a meaningful way?

Gerald Cohen: I agree that, because the commonly used consumer price index does not account for the cost of money – i.e. borrowing costs – this means that in times of high interest rates we tend to undervalue the cost pressures for U.S. households. We see this gap in U-M’s consumer surveys in which respondents decidedly assert that now is not a good time to buy a home or a car. Yet measuring cost of living and price increases is only one side of the measurement table. The other side is consumer sentiment, which reflects individuals’ experiences and feelings about economic conditions. Sentiment is highly nuanced and influenced by many factors, some of which have little to do with economic conditions – e.g., partisanship, which I discuss above. And, underscoring what Dr. Kuhnen points out, consumers are reasonably positive about current conditions yet cautious about the future, which is understandable given recent inflation, elevated interest rates and considerable uncertainty about geopolitical events.

Among the recent optimistic economic indicators, few come from the housing sector, as persistently high housing costs sully an otherwise positive economic picture. In fact, the ratio of median home price to median household income reached a record high of 5.6 in 2022, according to Harvard’s Joint Center for Housing Studies. And while there are signs that rental markets are cooling, the number of cost-burdened renter households – those spending more than 30% of income on rent and utilities – rose to 22.4 million in 2022, also an all-time high.3

Drawing on your recent research on the U.S. housing market, to what degree are elevated housing costs bringing down consumer sentiment?

Sarah Dickerson: There’s evidence that the cost of housing does in fact influence consumer sentiment. Yet while sentiment remains below 2019 levels, U-M’s Consumer Sentiment Index has risen since mid-2022, and overall sentiment in March 2024 exceeded expectations. Some of this increase can be attributed to trends in the housing market, which has recently shown some positive signs: Pending listings and year-over-year housing inventory increased in March and April. Consumer perceptions of conditions for both buying and selling homes have likewise improved since the end of 2023. Yet concerns about housing affordability and rate hikes persist, as the median sales price of homes remains high, and the proportion of consumers who expected mortgage rates to fall over the year ahead declined in both March and April. We should watch these trends closely to give us an idea of where consumer sentiment is headed.

What policies could be enacted to bring down housing costs?

Sarah Dickerson: Put simply: We need more housing. To date, 2024 has seen modest increases in year-over-year new listing growth, but affordable housing inventory still falls short of demand. This shortfall has led to stiff competition for a limited pool of available homes, which translates to high home prices.

There are multiple avenues to increase housing inventory. The main way is to build “missing middle” homes – moderately sized, low-cost dwellings, such as townhomes, duplexes and small multifamily units. To promote the construction of missing middle homes, policymakers and homebuilders would do well to streamline and accelerate the usually slow and complicated housing permit approval process. Local governments should also examine and reform their zoning policies to ensure that all potential construction sites are evaluated. Exclusionary zoning practices are far too common in the U.S., and these policies restrict the construction of affordable housing. By challenging the practical and legal barriers to upending outdated zoning policies, we can start to build affordable homes in many more locales.

Drawing from your expertise in household finance and economic inequality, how might income inequality contribute to gloomier-than-expected consumer sentiment? And what can be done in the short and medium term to increase equitable outcomes for American households?

Paige Ouimet: Before addressing its influence on sentiment, we have to agree on how to measure inequality. It is difficult to make progress on such a complex problem if we are not aligned on what we are measuring. Consider, for instance, income inequality: Are we concerned about differences in gross pay or are we more interested in differences in net pay, after accounting for taxes and government transfer programs? I think both are important metrics and should be measured. Too often, debate on inequality centers on vague definitions and incomplete measures, stoking disagreement and division, as various measures of inequality exhibit differing trends and lend themselves to disparate conclusions and prescriptions.

There are many policy levers that could be pulled to address inequality. Research has shown, however, that regulations may induce firms, employees and consumers to modify their actions in ways that undo some of the expected benefits of the new policy. An example of this sort of unintended effect that I have uncovered through my research is that nondiscrimination regulations can actually harm low-wage workers by reducing overall employment. It is important to anticipate these kinds of consequences and enact policies that minimize unintended rebound effects. Among the most promising solutions for creating equitable opportunity is to ensure that all Americans have equal access to a quality, low-cost education. Achieving equitable educational outcomes would undoubtedly lead to greater economic equality.

Regarding consumer sentiment, income level is certainly a key factor determining how individuals feel about the economy. We see this evidenced in the survey data, which shows that households in the lowest third of income earners consistently express the lowest consumer sentiment.4 Different economic indicators have dissimilar effects on households depending on their income level. Inflation has a particularly strong, negative effect on low-income households because low-wage individuals and families spend a large portion of their income on necessities, namely housing, food and fuel. If you’re a family of four spending more than half of your income on rent and food, and then those expenses increase by 20%, that level of inflation could lead to insolvency and destitution. It would certainly be a major stressor.

Interest rate hikes, on the other hand, tend to affect middle- and high-income household sentiment more, as they represent a large share of potential homeowners whose mortgage payments stand to increase with higher rates. U-M’s survey data shows this effect: From 2022-2023, the gap between the sentiment of top-tercile and bottom-tercile income households closed, and for a four-month period the lowest-earning households expressed greater sentiment than the middle- and high-income respondents, which is unprecedented in the survey’s recent history. The good news is that overall sentiment has increased among all income households since their low in 2022, and this uptick coincides with wage growth, especially for low-wage workers, a trend I expect to continue. The wage gains are small but at least in the right direction and hopefully represent the start of a long-term trend.

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