Over the past year, the Consumer Price Index, a key inflation measure, has increased by 8.5%, the fastest in 40 years. Even worse, inflation is likely to remain high in 2022. The Producer Price Index, which measures inflation before it reaches the consumer, indicates that there is a lot more upward price pressure to come.
The war in Ukraine will continue to have a significant inflationary impact on the economy, especially on food and energy prices. In addition, the rapidly growing number of new Covid cases in China could constrain global supply chains even further, fueling even more inflation.
To combat rising prices, the Fed plans to respond with significant interest rate hikes. Typically, with high inflation reducing the purchasing power of households and rising interest rates depressing their willingness to spend, the result would be a falloff in consumer spending.
But while we’re unlikely to see that dynamic play out with services, consumer goods spending is sure to plummet. Nearly two-thirds of consumer spending is on services, a category that is still very depressed relative to pre-pandemic levels because it disproportionately involves in-person interaction. But that is changing quickly as consumers feel less fearful about Covid-19.
Spending on live entertainment, rail travel, movie theaters and foreign travel in the United States, for example, is still less than half of pre-pandemic levels. And spending on intracity mass transit, water transportation and hairdressing and personal grooming is still less than two-thirds of pre-pandemic levels. While these categories, and others, may not fully recover this year, they have been growing rapidly in recent months, even despite price increases, and are expected to continue to do so for the remainder of this year. Employment in the leisure and hospitality industries, for example, has been growing at a 13% annual rate in the six months through March.
But with inflation squeezing consumer wallets, the extra money they are spending on services must come from somewhere. That source will be consumer spending on goods, which is facing a perfect storm for depressed spending. In many households, accumulated savings from the pandemic period, which boosted consumer spending, will dwindle. It’s hard to decrease your consumption of food or energy even as inflation takes prices higher — so consumers will have even less money to spend on other things. And the increase in interest rates will not only reduce spending on housing, but also on housing-related goods, such as appliances and furniture.
How low will consumer spending on goods fall? A lot will depend on what defines the new normal. The pandemic forced all of us to spend more time at home and, correspondingly, to spend more dollars on our home environment. If this new focus on nesting has come to be a permanent change in mindset, consumers may continue to prioritize spending on goods, at least within their capacity, thereby offsetting what might otherwise be a steep drop.
But for retailers and wholesalers and for industries related to producing, transporting or storing consumer goods, the party is very likely over.