The Challenged Consumer

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My first job out of graduate school, in the early 1990s, was as the consumer economist for the economic consulting firm of DRI/McGraw-Hill, in Lexington, Massachusetts.?One weekend each month, we would run a U.S. macroeconomic forecast.?(It always had to be over the weekend, as this was the only time when we could get our own clients off our mainframe computer.)?Anyway, on Saturday afternoon, having produced some preliminary numbers, we would gather around a huge conference-room table and discuss how the forecast was shaping up.?

My colleagues were smart and seasoned economists and very patient with someone clearly just waking up to how forecasts are constructed in the real world.??However, I believe they did somewhat resent my position as “the consumer guy”.?Because then, as now, consumer spending accounted for roughly two-thirds of GDP and they would spend much of the weekend vainly trying to offset what they saw as my undue optimism by hacking away at their forecasts for investment, trade and government spending.

Over the years since then, my faith in American consumers has been vindicated time and again.?American consumers have always been more willing to buy stuff they don’t need with money they don’t have than any other consumers in the world and this propensity has frequently helped dig both the U.S. and global economies out of a jam.

However, today’s American consumers are beginning to look more like an aging star quarterback with a beaten up offensive line facing an ever more ferocious rush. ?While there are still occasional shows of bravado, it is getting ever harder for consumers to engineer a general economic advance.?This is particularly relevant when thinking about the risk of recession, the probability of lower inflation and a change in Federal Reserve policy in 2023.

The Saving Rate Problem

The biggest problem facing consumers is that temporary government stimulus over the pandemic allowed them to increase spending to a pace that is just not sustainable.?

The personal saving rate, (which is calculated as the difference between disposable income and personal outlays, as a percentage of disposable income), had been remarkably stable in the decade before the pandemic, ranging from a low of 6.1% in 2013 to a high of 8.8% in 2019.?It then vaulted to 17% in 2020 and 12% in 2021, reflecting a huge infusion of government aid.?Some of this money was used to pay down credit card debt while other money was stashed away in bank accounts and financial assets.?However, consumers also used government money to increase their spending, leading to higher rents and a surge in inflation generally.?Consumer spending, in nominal terms, fell by 1.9% in 2020 but then surged by 12.7% in 2021 and appears set to increase by over 9% this year.?

The problem, however, is that the personal saving rate is now on track to average just 3.2% for 2022 as a whole.?Indeed, we expect that, on Friday, the Commerce Department will report a saving rate of just 2.3% for November, matching the second lowest monthly reading since 1959.?

At first glance, this doesn’t seem too worrying.?Saving is, after all, a rather discretionary use of income and the economy should be able to function fine even if everyone saves a little less than normal.?

However, the problem is that the aggregate saving rate reflects very different behavior across households.?Better off households generally save far more than 2.3% of their income.?But the majority of households are now dissaving – racking up debt to try to maintain their standard of living.?Evidence of this can be seen in a 15% increase in revolving credit in the year ended in October 2022,?according to the Fed, and a 24% year-over-year rise in hardship withdrawals from 401k plans, according to the Empower Institute[1].?As more households reach the limit of what they can reasonably borrow, the aggregate saving rate should move up.?However, even a partial return to a normal saving rate over the next two years would require consumption to grow significantly more slowly than disposable income.

The Income Problem

So how fast can disposable income grow?

Employee compensation accounts for over 60% of personal income and was up 6.4% year-over-year in October.?Assuming an unchanged average workweek, its growth comes from gains in new workers and increases in wages.?In the year ended in November, payroll employment grew by 3.3% or a whopping 4.9 million jobs.?However, these gains will likely be severely curtailed going forward by a lack of available workers, downturns in construction, manufacturing, technology and finance and generally falling business confidence.

In addition, while the Fed appears concerned about wage inflation, the reality is that year-over-year wage growth has lagged behind consumer inflation for more than a year now, with little evidence that this is leading to increased industrial action or strikes.?Slower job growth and wages gains falling short of inflation suggest that rising labor income will not be sufficient to spur greater consumer spending going forward.

Beyond employee compensation, other areas of income are likely to grow at different speeds.?Proprietors’ income will be hit by the slowdown in construction and a general profit squeeze for small businesses while personal dividend and interest income should rise steadily.?Government transfer payments will likely increase only slowly, after a healthy cost of living adjustment in January, as divided government in Washington ends any chance of further stimulus either in the form of higher government spending or tax cuts.?

In short, even with a steady decline in inflation, real disposable income looks likely to rise only very slowly over the next two years and, if the saving rate even gets half way back to a normal level, real consumer spending growth could flatline.

Other Issues for Consumers

Of course, there are other factors that will impact the growth in consumer spending.

Demographics should continue to be a drag.?This Thursday, the Census Bureau will release its population estimates for the year ended June 30th, 2022.?Overall, we estimate the population grew by about 850,000 – higher than the 400,000 of the previous year but still far lower than 2,000,000+ annual gain seen in the decade before the pandemic. The 850,000 gain would reflect the second lowest number of births since 1984, a sadly elevated death rate and still significantly lower legal immigration than a decade ago.?Looking at each of these components separately suggests population growth of roughly 1,000,000, or 0.3%, over each of the next two years – not enough to promote any boom in consumer spending.

The continuing collapse in housing starts and existing home sales, which should be very evident in data due out on Tuesday and Wednesday, will continue to drag on the demand for furniture, appliances and moving services.

A partial recovery in financial markets in the fourth quarter and slightly better confidence due to lower gasoline prices may be a small positive for consumption entering 2023.?However, offsetting this will be a drag from the resumption of student loan payments, which will likely kick in the second half of the year.?It also is looking more likely that this resumption in payments won’t be offset by the partial forgiveness of student debt proposed by the President, as the Supreme Court is now actively reviewing the constitutionality of this plan.

One positive for consumer spending is pent-up demand for new vehicles which have been hard to find over the past year due to supply-chain issues.?However, there are also many other items currently cluttering the basements of America after dramatic increases in consumption during the pandemic and spending in these areas will likely be curtailed.?

Finally, the pandemic may have resulted in some long-lasting changes in consumption patterns.?A permanent increase in working from home could mean a lower equilibrium level for vehicle sales.?Home streaming of just-released films will make it very difficult for many movie theatres to survive while the growth of on-line purchases is unlikely to subside to pre-pandemic levels, endangering business for many small bricks-and-mortar retail outlets.

Consumers and the Fed

Adding it all up, it looks like the next two years will be very slow ones for American consumers and this should have a significant impact on Fed policy and financial markets.?Very slow growth in consumer spending should help reduce consumer inflation.?However, it could also mean that the downturn that the Fed has engineered in housing, combined with weakening trade, due to a high dollar and slumping overseas growth, is sufficient to push the U.S. economy into recession.??

Importantly, assuming that no fiscal help will be forthcoming from a now divided Congress, pressure will increase on the Fed to first end fed funds rate hikes before their now forecast peak of 5.00%-5.25% and then to cut rates by the end of 2023.?

Ultimately, we believe that the Fed will give into this pressure.?Because of this, while 2023 is looking increasingly challenging for U.S. consumers and the U.S. economy overall, it could be a better one for financial markets as the Fed pivots to a more appropriate policy for an economy now more threatened by recession than inflation.

Read the On the Minds of Investors article, Is inflation finally slowing?, for more insights on the November CPI report.

[1] Empowering America’s Financial Journey, The Empower Institute, November 2022

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