How Do Inflation Headwinds Impact Consumer Discretionary Spending?
Consumer Spending & Inflation
Inflation significantly affects what consumers choose to buy, where they decide to go, and what they choose to do, especially when there is talk of a potential recession. Historical data backs this statement, consumers are predictable during unprecedented times they adjust their behaviors to coincide with the several phases of the economic cycle. These behaviors all have an effect, either positive or negative, on certain aspects of the economy. The sectors heavily impacted by rising inflation rates include food, travel, motor vehicles, and durable goods.
Consumer spending in the United States increased more than expected in September while underlying inflation pressures remained elevated, putting the Federal Reserve on track to raise interest rates. Americans may be concerned about inflation, but they continue to shop, which keeps the economy growing for another quarter. September’s figures indicated that momentum increased after the quarter, which bodes well for spending in the final months of 2022.
According to the U.S. Bureau of Labor Statistics, food accounts for less than one-seventh of the average consumer’s total expenditures. This statistic follows Engel’s law; as Americans’ income increases, the proportion of income spent on food decreases on a relative basis. Experts hypothesize that a higher proportion of food expenditures will be spent at home rather than away from home. Inflation rates will also affect what grocery stores families choose to shop at, hurting higher-priced grocery stores throughout the area. Furthermore, expenditures in the food-away-from-home component is expected to shift toward limited-service restaurants rather than full-service restaurants as consumers seek ways to stretch their spending dollars.
Graph 1 demonstrates how expenditure on food as a percentage of total consumption has decreased over the past several decades -in the late 1970s, food accounted for over 20 percent of consumption- but as of April 2022, that percentage had dropped to just 13.5 percent. Consumption of other goods has increased as disposable incomes have increased over time, reducing the proportion of overall spending on food.
Graph 2 shows the percentage of food consumed at home against food consumed away from home over the previous six recessions and the year previous to each recession. Interestingly, compared to the 12 months before the recession, the share of food consumed at home decreased slightly during the recessions of 1981 and 2001. In contrast, the eating-out percentage rose during three of the previous six recessions. Consumers do not dine out less during times of inflation or recession; they simply choose to eat at cheaper restaurants.
The ratio of restaurant expenditure at limited services versus full-service restaurants is a better indicator of how consumer behavior changes during recessions. Fast food businesses are examples of limited-service restaurants that are usually less expensive than full-service restaurants and may be more alluring during economic downturns. Graph 3 demonstrates that the ratio between restaurants with limited versus complete services tends to rise during recessions; however, not every notable increase in the ratio is always accompanied by a recession.
Travel spending considers data from both airlines and hotels. Data has shown that spending on travel as a share of total PCE (Personal Consumption Expenditures) price index usually drops during recessions. This is understandable given that travel is a significant component of discretionary spending and is highly sensitive to economic conditions. The decline in travel share could be attributed to consumers canceling vacations to save money or switching to less expensive travel destinations. It is worth noting that the travel shares of total PCE fell abruptly in 2001 following the September 11th attacks and again in 2020 due to COVID-related travel restrictions.
The Bank of America credit and debit card data suggests that travel rates have been at their highest since the pandemic. This level can be attributed to the large percentage of people waiting to travel and vacation for two years. Since people could not leave their homes during this period, revenge travel has significantly impacted the number of people now taking part in leisure travel. People are taking back the time lost to the pandemic, even if inflation rates are continuously rising. For this reason, experts predict resilience in travel spending over the next few years. This is good news for the hospitality industry.
Recessions tend to positively impact auto parts retailers because consumers will be more likely to hold onto their cars for longer periods instead of spending extra money on a new car. Data has shown that the relative importance of new cars dramatically drops during times of high inflation. When a recession hits, the ratio of new vehicle expenditures to used vehicles falls from about 2.6 to 1.6. The recovery period demonstrates that the relative importance of new cars is significantly higher than during the recession but still far below the peak level. During the recession, the relative importance of new and used vehicles fell by about one-quarter and has only slightly recovered.
Durable goods are much more sensitive to the economic cycle. These goods include furniture, appliances, and autos. Spending on durable goods is an excellent indicator of real GDP growth since they usually have a much higher sticker price and are more likely to be postponed by consumers during declining economic conditions. Durables’ relative importance fell by nearly 20 percent between the boom of 2007 and the recession in 2011. The decline is primarily due to vehicles, but the relative importance of furniture and appliances has decreased by about 25 percent. All the categories have a higher relative importance in recovery than in a recession, but they are still lower than previously.
Data has shown that time and time again, consumers will drop several small expenses to save money during times of economic turmoil. However, there will be consumers whose behaviors do not react to inflation rates. Still, in general, the consumer price index does a great job of reflecting the kinds of adjustments consumers are expected to make as the economy goes through a high inflationary period.