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- A group of economists may have uncovered the reason for the disconnect between American consumer sentiment and the underlying economy.
- It all depends on how experts measure inflation and what they ignore.
- Economists said rising borrowing costs explained more than 70% of the sentiment gap.
Over the past year, experts have been perplexed by the disconnect between how Americans feel about the economy and hard economic data that suggests things are going pretty well.
Although sentiment has improved slightly in recent months, “recession” remains on the minds of economists. Now, their group has created an interesting model that suggests that much of people’s dissatisfaction with the economy stems from interest rates.
In a research paper published in February by the National Bureau of Economic Research, the authors, economists from Harvard University and the International Monetary Fund, investigated whether rising interest rates may have fueled Americans’ dissatisfaction with the economy. analyzed.
To do this, they developed a unique inflation calculation that incorporates the rising costs of borrowing, such as buying a home or a car. They then created two separate forecasts of economic sentiment using both the new inflation measure and the Bureau of Labor Statistics’ official Consumer Price Index, a commonly cited measure of economic mood. We compared it to the University of Michigan’s Consumer Sentiment Index.
When economists used the official CPI measure, there was a wide gap between forecasts and actual sentiment. However, using a revised inflation measure, we find that the sentiment gap in 2023 has narrowed by over 70% of his time. This suggests it’s a more accurate way to measure how Americans feel about the economy.
In short, standard inflation measures don’t capture how expensive debt has become these days, even though this may be a major factor explaining Americans’ dissatisfaction with the economy. is.
“Given the hard data, there still seems to be a bit of excessive pessimism and bad vibes, but if you just look at inflation and unemployment, “It’s not as big as you could get if you were to do it.” He said this on an episode of the podcast “Plain English” released on March 5th.
Popular inflation indicators in the US no longer take interest rates into account
Michigan’s Consumer Sentiment Index has been trending upward in recent months, but Americans felt more positive about the economy in February than in any month since December 2013, when sentiment plummeted due to the pandemic, to early 2020. He still had a harsh view.
Traditionally, many economists have used the “misery index,” which is the sum of the inflation rate and unemployment rate, as one of the tools to measure the health of the U.S. economy. When prices are high and many people are unemployed, things are probably not going well.
But the paper’s authors, including former Treasury Secretary Larry Summers, said the misery index had significant shortcomings that motivated them to develop an alternative measure of inflation. That means interest rates are no longer considered.
In 1983, the BLS changed the way it calculated inflation. One of the biggest adjustments was how to determine shelter inflation, one of the largest parts of the consumer price index that is supposed to reflect the cost of housing for Americans.
Before the change, house prices and mortgage rates were among the factors used to determine shelter inflation. However, the situation has changed after the BLS changes, which were made in part because many people now view housing as an investment rather than just consumption.
Currently, shelter inflation is calculated using the rental price and the equivalent cost of renting an owner-occupied home. This comes despite the fact that rising mortgage rates are one of the main reasons why mortgage payments reached record levels last year. (contributing to the above) does not have a direct impact on shelter inflation.
In fact, the impact of rising interest rates is nowhere directly accounted for in the official CPI report, even though it also contributes to higher car payments and makes credit card debt much more expensive. do not have.
“Americans have seen interest rates on credit cards, auto loans, and mortgages skyrocket in the post-pandemic period, but that hasn’t been reflected in the CPI,” said Harvard’s Kramer. .
That’s why economists have developed their own measure of inflation, which they believe can more accurately predict economic sentiment.
“When you include interest costs in the consumer price index, as was done in the 1970s, you find that the economy is not as great as everyone says,” Cramer said. “And given that consumers have had to deal with these high interest costs over the past few years, their gloomy mood is a little more explainable.”
Kramer said there has been additional evidence in recent months of the impact interest rates have on consumer sentiment. From November to January, just as mortgage rates fell from recent peaks, Michigan’s Consumer Confidence Index posted its largest two-month increase since 1991.
Cramer said it’s not surprising that surging interest rates appear to be impacting how Americans view the economy, given the impact they have on people’s wallets. He said he and his fellow co-authors found that rising interest rates affected sentiment in other countries as well.
The increased interest did not fully explain the gap between grim economic indicators and sentiment. Some point to increased political partisanship and negative media coverage as other explanations.
But if the Federal Reserve begins lowering interest rates this year, as most expect, leading to lower borrowing costs for mortgages, auto loans, and credit card debt, some Americans will feel less confident about the economy. It might get better. And that could be good news for President Joe Biden’s re-election chances.
“If we start lowering rates, I think it’s going to have a big impact not only on the real economy but also on how people interpret the economy,” Cramer said.
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