We should not believe consumers who say they’ve got the blues

If you ask shoppers if now is a good time to buy stuff or if the economy is doing well, take cover. Surveys suggest that even though the US, Eurozone and UK are close to full employment and real incomes are rising, consumers are miserable.

The University of Michigan’s consumer sentiment index was at 52.2 in April, having only been lower briefly in 2022 and in 1980. In Britain, the very long-running economic optimism index from Ipsos Mori has fallen to its lowest ever level since the survey began in 1978. Although the Eurozone consumer confidence index is not quite plumbing these depths, it also dropped sharply last month with deterioration in all four component parts of the index.

The indicators are seen as a rapid insight into coming spending patterns and economic health, since household consumption is the largest component of GDP.

But what if something has happened and these surveys no longer provide the information they once did?

Federal Reserve chair Jay Powell thinks something fishy is going on. “There have been plenty of times where people are saying very downbeat things about the economy and then going out and buying a new car,” he said after the Fed’s March policy meeting. Sentiment has plunged further since then.

What is going on in the US?

The chart below shows the level of the Michigan consumer sentiment indicator and the annual growth of consumer spending since 1985. The levels are expressed in standard deviations from the mean so the two indicators can be shown on one chart with a single y-axis. This transformation of the data shows whether the indicator is above or below its long-run average and the extent of any deviation.

The chart shows the relationship between consumer sentiment and real growth in private consumption has broken down. During Donald Trump’s first administration, sentiment was generally above average, but spending was nothing special. Yet since the pandemic, the opposite has been true — both during the 2021-22 inflationary period and now.

It is very difficult in the US, however, to say things about the economy without mentioning a chart of consumer sentiment by political party affiliation.

Since 2016, Republicans report that it is a good time to spend only when their man is in the Oval Office and vice versa. So it cannot be that surprising that the data has lost its power as an economic indicator. It seems now to measure the degree of partisanship — and Democrat-leaning consumers are really unhappy at the moment.

But this is a very US-centric view of the world. To avoid making the common mistake of thinking the US is everything, what is happening in Europe?

Europeans are miserable too and spending

If you look at the equivalent chart for the UK with two different consumer confidence indicators, the same pattern as the US also emerges. Since Covid-19, even though consumption has not been that strong, both the GfK consumer confidence indicator and the Ipsos Mori economic optimism indicator have been significantly weaker. Overall, there used to be a reasonable fit between the data, which has broken down.

Not to be outdone, the same pattern can be seen in Eurozone data. Sentiment across the single currency area is more volatile than consumption. Recently it has been incredibly weak, while real household spending has held up better.

It seems that US political polarisation, while clearly undermining the value of sentiment indicators, is not the only thing to worry about.

Some sleuthing from the Fed

What we really need is to track the actual spending habits of a sample of consumers against the same sample’s sentiment scores. This is exactly what some enterprising Fed officials have done in a new research project.

They combined a long-running survey of actual spending patterns, in which households scan their receipts into an app, with subjective questions about how much respondents’ incomes, spending and sentiment had changed in recent years.

So long as households consistently and accurately record their receipts, the researchers can examine individual real spending growth and individual inflation rates and compare them with sentiment. The results are fascinating.

First, consumers overestimate the inflation they have faced. This is not a surprise, but 24 per cent thought their inflation rate over the past five years had been over 40 per cent. In fact only 1.7 per cent of the sample had experienced such high inflation. Inflation, as I have documented before, makes people mad with rage.

Second, sentiment was strongly linked to consumers’ perception of their real spending. Those that felt least confident about their finances said their incomes had grown much slower than their spending, even though they were often factually wrong. This weak economic sentiment was amplified if they felt they had to take action to cut back due to inflation.

Third, although households that said they were much better off than five years earlier had higher spending growth than those who said they were much worse off, the differences in the distributions were not large, as the chart below shows.

In an inflationary environment, therefore, economic sentiment is likely to be weak and could well disconnect with real spending levels. It is not just politics. Consumers around the world are likely to be angry, but might still be spending hard. Sentiment indicators may not be much use until memories of inflation fade.

What I’ve been reading and watching

A chart that matters

Scott Bessent spent last Thursday talking about how much the two-year yield on US Treasuries had fallen before it promptly rose 0.25 percentage points.

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“We are seeing that two-year rates are now below Fed funds rates, so that’s a market signal that they think the Fed should be cutting [rates],” Bessent said.

He is correct in his analysis. The trouble is that financial markets have been a terrible predictor of the federal funds rate recently, as the chart below shows.

Since the middle of last year they expected six quarter-point rate cuts in 2025 last September, then in January only one, and now almost four. Market participants change their minds regularly and will look for signals at Wednesday’s Fed meeting.