What’s Behind the Recent Slump in Consumer Sentiment?

The recent slump in how U.S. consumers are feeling about their financial prospects and the country’s economic prospects has been turning heads. What is usually a reliable indicator of how the economy is performing in the near term has been foundering in the last few years while many measures of economic performance have been strong.

Observers have cited negative economic news disproportionally circulated on social media as one possible reason for poor sentiment that is disconnected from a robust economy. Another common view is that while inflation is cooling, the price level is still higher than a few years ago and consumers have not yet adjusted. High prices are a factor, but they primarily work by eroding incomes, which has been found to have considerable influence on consumer sentiment.

Why Fret over Sentiment?

Household consumption accounts for over two-thirds of U.S. gross domestic product (GDP), so when the consumer is dispirited, economists take note. A drop in consumer sentiment is typically followed by a recession. The figure below shows one measure of consumer sentiment, the University of Michigan consumer sentiment index (henceforth sentiment), for each month from January 1978 through December 2023.The Surveys of Consumers is distilled into the consumer sentiment index based on five questions about respondents’ personal financial conditions and expectations, expectations and assessments of the country’s economic conditions, and whether now is a good time to purchase durable goods. The respondents can answer with a positive, negative or neutral assessment. For each of the five prompts, a relative value is calculated based on the number of positive responses out of total responses, and the final index is created through an aggregation of each of the five relative values. Recessions, shaded in gray, accompany almost all of the major dips in sentiment. Once the recession ends, sentiment is expected to rebound, so we can generally see sentiment as a good indicator of the direction in which the economy will move.

University of Michigan Consumer Sentiment Index

SOURCE: University of Michigan Surveys of Consumers.

In June 2022, sentiment hit its lowest point ever on record—below the troughs of the pandemic in 2020 and the Great Recession, 2007–2009. What has been puzzling economists is that the usual explanations don’t apply. Over each of the last four quarters, real GDP growth grew stronger on a year-over-year basis, from 0.7% to 3%. The civilian unemployment rate has also been historically low for most of the pandemic recovery.

The next figure shows the year-over-year real GDP growth and the employment rate (the percentage of the labor force that is working) overlayed with sentiment from 1980 through 2023. All three quarterly series have been standardized based on their 1980–2019 averages and standard deviations from those averages. A value of 0 here represents the average value over the 40-year period. As shown in the figure, the employment rate is 1.5 standard deviations above its long-run average as of the third quarter of 2023, GDP growth is at its average, but sentiment is almost 1.5 standard deviations below.

Historical Deviation of Consumer Sentiment, GDP Growth and Employment Rate

SOURCES: University of Michigan Surveys of Consumers, Bureau of Economic Analysis, Bureau of Labor Statistics and authors’ calculations.

NOTE: The employment rate is calculated as 100 minus the unemployment rate (e.g., an unemployment rate of 4% is an employment rate of 96%).

Sentiment and Income Growth

The poor sentiment seems more reasonable, however, when examining year-over-year real growth of personal income excluding current transfer receipts.Current transfer receipts are income payments to persons for which no current services are performed (e.g., government social benefits) and net insurance settlements. As shown in the next figure, throughout most of years since 1980, annual income growth and sentiment hit their peaks and troughs almost perfectly in step. Furthermore, except for a few quarters between 2001 and 2003, and again in 2016, sentiment never stayed elevated while real income growth remained below average for an extended period. Most importantly, since 2020, real personal income growth has been below its long-term average and quite significantly.The obvious exceptions are the very high growth rates in second and third quarters of 2021, when income was returning to its pre-pandemic levels after plunging in the same quarters in the prior year.

Historical Deviation of Consumer Sentiment and Real Personal Income Growth

SOURCES: University of Michigan Surveys of Consumers, Bureau of Economic Analysis and authors’ calculations.

NOTE: Personal income data excludes current transfer receipts.

Even though economic output and employment were both up in 2021, households began to experience a sharp increase in the cost of living. Rapid increases in consumer prices eroded income gains, causing real income growth to be negative in the final three quarters of 2022; more generally, real income growth has been below its long-term average since the first quarter of 2022. This run of lagging incomes may have put downward pressure on consumer sentiment starting in the second half of 2021. But, as inflation slowed and real income growth accelerated, consumer sentiment also showed signs of improving, with sentiment steadily increasing since headline inflation passed its peak in June 2022.

Notes

1. The Surveys of Consumers is distilled into the consumer sentiment index based on five questions about respondents’ personal financial conditions and expectations, expectations and assessments of the country’s economic conditions, and whether now is a good time to purchase durable goods. The respondents can answer with a positive, negative or neutral assessment. For each of the five prompts, a relative value is calculated based on the number of positive responses out of total responses, and the final index is created through an aggregation of each of the five relative values.
2. Current transfer receipts are income payments to persons for which no current services are performed (e.g., government social benefits) and net insurance settlements.
3. The obvious exceptions are the very high growth rates in second and third quarters of 2021, when income was returning to its pre-pandemic levels after plunging in the same quarters in the prior year.