Should the U.S. be worried about deflation?
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Patrick Cowles wrote in with two questions:
1) Given the split between political preference and consumer sentiment, should we even trust sentiment as a leading indicator anymore?
2) I’ve always heard that deflation causes consumers to delay purchases as they look for better value. But won’t consumers purchase those goods eventually? Doesn’t it all even out in the end?
Is consumer sentiment a reliable economic indicator?
When a Democrat is in the White House, supporters of that party are generally more confident about the economy and where it’s headed. Similarly, Republicans will feel more confident if there’s a Republican in power.
“What we can see since the ‘80s is that there has always been a partisan gap in sentiment,” said Joanne Hsu, director of the University of Michigan’s consumer surveys. Each month, the University of Michigan publishes its index of consumer sentiment.
“Consumer sentiment is, ultimately, a measure of how people feel about the economy — not just how they feel about the economy right now, but also where they think the trajectory of the economy is going,” Hsu said.
Another well-known measure of consumer confidence is published each month by The Conference Board. The Federal Reserve Bank of St. Louis says people pay attention to consumer confidence indexes because they are considered early signals “regarding the strength of the broad economy.”
This month, the University of Michigan’s index of consumer sentiment stands at 68.1. Broken down by political party, it’s at 89 for Democrats and 50.6 for Republicans, revealing a 38-point gap. Back in June 2020, during the administration of Republican Donald Trump, it stood at 58 for Democrats and 101 for Republicans, a 43-point gap.
Hsu said that while there has always been a partisan divide in the index, it has grown over time. But many consumers call themselves political independents. For them, the index currently reads 64.2.
“Independents are always in the middle,” Hsu said. “So we don’t actually see a break in sentiment around elections or a change in party in power. And that’s because our index is an average over consumers of any political persuasion.”
She noted that the level reported in the index lines up “quite well” with how independents feel.
What’s the problem with deflation?
If the U.S. economy were to enter a rare period of deflation — when prices are declining — people may indeed hold off on purchases, particularly big-ticket items like washing machines and cars, explained John Horn, a professor of practice in economics at Washington University’s Olin Business School in St. Louis.
Here’s why that’s a problem.
“If enough people stop buying washing machines and going on trips and buying cars and doing all those bigger, sort of discretionary purchases, then what happens is the people who are selling the cars or making the cars or running the hotels — they stop having as much business,” Horn said.
And if they reach that point, Horn said, two things could happen: They’ll drop prices even further to entice customers, and/or they’ll lay off workers.
It could drive a vicious cycle. Falling prices would reinforce the notion that consumers made the right choice in delaying their purchases. If, at the same time, companies let workers go and unemployment rises, then laid-off workers who need these goods won’t be able to afford them, Horn said.
“We don’t have the same problem with inflation because when prices are going up, and if I expect prices to keep going up, then I want to say, ‘Hmm, do I want to wait six months to buy that washing machine? Or buy it now because I think the prices might go up?’” Horn said. That’s why you’ll probably decide to buy it now.
But the good news is that the Federal Reserve and/or other government agencies would probably intervene to combat deflation.
“Governments oftentimes step in pretty quickly to try to stop that because it can be really hard, once it gets ingrained in the economy, to break that cycle,” Horn said.
After the U.S. saw dramatic inflation when supply chains broke down and pandemic relief was widely distributed, price increases have cooled off. Consumer prices rose 3.7% in August compared to a year earlier, according to Labor Department data. Meanwhile, the personal consumption expenditures price index, excluding food and energy, increased just 0.1% between July and August.
Some financial observers, among them the German investment firm Wermuth Asset Management, have rung alarm bells because of the risk that the U.S. could soon face deflation. Commercial real estate is showing signs of weakness, while pandemic savings are drying up (and might even be gone).
But Horn isn’t worried. He sees little risk at the moment, he said, because U.S. inflation is still above the Federal Reserve’s 2% target.
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