U.S. Inflation And The Rational Consumer

Consumers know a bad deal when they see one. They realize that when prices go up, purchasing power goes down. Data from the University of Michigan, contained in Haver's database, paint a compelling picture. The simple relationship, shown in the accompanying chart, indicates a strong correlation between consumers' twelve-month price inflation expectations and consumer sentiment, i.e., the sense of whether something is good, bad, or insignificant. Therefore, the March surge in inflation expectations to 5.4%, fueled by higher gasoline prices, accompanied the 12.0% m/m decline in sentiment, reported last week.

The relationship does not end, of course, with what higher prices do directly to purchasing power. Other effects include its raising the likelihood of higher interest rates (see the early 1980s), lowering of the foreign exchange value of the dollar and the potential for spillover to foreign economies. So what do consumers tend to do in this environment? Often, they buy today before it's more expensive tomorrow. Or maybe they shift buying towards less expensive items. The hard truth is that when buying power is eroded, the consumer does less buying. And the scenario can play out quickly. That's because the index of consumer sentiment also has a strong correlation with the three-month change in real consumer spending.