Consumer spending set to slow as inflation drags on households

The resilient consumer is poised for a pullback.

Ramped-up spending that powered the economy has also driven household borrowing and depleted savings. Despite improved wage growth, the painful reality of inflation has pummeled households. Government data scheduled for release Thursday is expected to show retail sales ticked up 0.1% in August from the prior month, a slowdown from July’s 0.7% increase.

Signs of cooling consumer spending point to the next phase of the pandemic economy, where the perception of resilience is shaded by darker undertones. The complex picture highlights the Federal Reserve’s challenge in its interest-rate hiking campaign: The central bank wants to slow spending to bring down inflation. But consumer spending has also helped the US economy skirt a recession many anticipated earlier this year.

Read more: What the latest Fed rate hike plan means for bank accounts, CDs, loans, and credit cards

“If the American consumer can spend, they will,” said Michael Farr, chief market strategist for Hightower Advisors, and founder and CEO of Farr, Miller & Washington. “That said, the resilience of the consumer has been a surprise to nearly everyone.”

Signs of a slowdown ahead

The larger-than-expected spending spree coincides with a gloomier outlook from consumers, who see their financial prospects dwindling in the months ahead, new Fed survey data showed Monday. Respondents predicted their incomes would rise 2.9% in August, the lowest reading since the summer of 2021, according to the New York Fed’s Consumer Sentiment Survey for August. The data showed the percentage of households that reported it is harder to obtain credit hit a record high, with expectations for future credit access also dwindling.

Nicole Tanenbaum, partner and chief investment strategist at Chequers Financial Management, said heightened inflation has eaten away at household budgets, noting that credit card balances and delinquencies are steadily on the rise.

Read more: Credit card fees explained — 8 types you should know

“It is unlikely that these current levels of spending will prove sustainable, and we will see the consumer begin to pull back,” she said. “Reduced savings and increased debt, combined with the looming resumption of student loan payments for millions, should place further pressure on consumers going forward.”

Americans have been spending more even as they dig into their excess savings and as the job market loses some of its steam. The personal savings rate dropped to 3.5% in July, down from the recent high-water mark of 4.7% in May. Meanwhile, consumer spending trucked along, increasing by 0.8%. But experts say the elevated spending — bolstered by the savings during COVID, rising home prices, and strong capital markets — isn’t sustainable as consumers face an array of financial hurdles.

File - Shoppers cast long shadows as they head to their vehicles outside a Costco warehouse on July 11, 2023, in Sheridan, Colo. Although the Federal Reserve has sharply raised interest rates, consumer spending keeps growing at a healthy rate. (AP Photo/David Zalubowski, File)

As the Federal Reserve has sharply raised interest rates, consumer spending keeps growing. (AP Photo/David Zalubowski, File)

“Wages were not keeping up with inflation starting in the spring of 2021, but since early 2023, wage growth has been higher,” said Kristina Hooper, Invesco chief global market strategist. “The reality is that inflation remains elevated, which is challenging for households despite improved wage growth.”

The sense that the US consumer is losing momentum is showing itself in other ways. Rising interest rates, which makes borrowing more expensive, arrived alongside growing use of buy now, pay later plans. They allow consumers to purchase furniture, electronics, and even necessities like groceries on installment plans, without requiring a hard credit check to qualify for a traditional credit card. Almost half of US households have used buy now, pay later plans, according to an analysis by Apollo Global Management’s chief economist Torsten Slok, with usage rates climbing to 46% in 2023, up from 43% in 2022 and 31% in 2021.

“Typically, during times of economic uncertainty, consumers with minimal savings and deteriorating credit scores pivot to other forms of credit and buy now, pay later becomes one such arrangement,” said Jeffrey Roach, chief economist for LPL Financial.

An ‘inflection point’ for the economy

The story of a resilient consumer has other wrinkles, like a reliance on promotional offers from credit cards. Over the past two decades the percentage of newly issued credit cards that offered teaser rates — where consumers are charged no interest or at discounted rates for a trial period — has climbed from roughly 20% to 80%, according to research from Hong Ru, a visiting professor of finance at MIT Sloan School of Management. Ru analyzed data from 2000 to 2016 and found a rapid escalation in promotional offers over time. Even as interest rates overall remain elevated, some consumers are insulated from the higher cost of borrowing.

Accumulating debt in a high inflation environment still carries risk. Consumers that sign on to teaser rates likely expect they will pay their bills before the trial period ends. But borrowers might be myopic about their spending and overly confident about their ability to repay, said Ru, who conducted the research alongside Antoinette Schoar, a finance professor at MIT Sloan School of Management. Once the grace period of anywhere from 6 to 18 months ends, indebted consumers will face more expensive credit as well as the potential for penalty rates, he said.

The spending train has to come to a stop eventually. American consumers depleting their savings will likely bring the economy closer to an inflection point, said Farr. “The elasticity of consumer demand will at some point be faced with the inelasticity of the consumer’s wallet,” he said.

Historically, slowing demand can snap the economy back into a recession. The gathering storm of increasing consumer debt, tighter financial conditions and other indicators like the Treasury yield curve, has flashed warning signals. But the pandemic era has bucked historic trends and spawned unexpected twists and turns.

“It is worth pointing out that we have seen much in the last three years that is unprecedented, and also that unprecedented is not the same as saying impossible,” said Farr. “We may avoid recession, but it would be wise to prepare rather than hope for an outcome never seen before.”

Hamza Shaban is a reporter for Yahoo Finance covering markets and the economy. Follow Hamza on Twitter @hshaban.

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