Is Inflation Causing Americans to Stop Spending?

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Perhaps frugality is back.

The American consumer, after seemingly brushing off the Great Recession far faster than expected, seems to be headed back into retreat. And it appears this time not to be the job market that is doing it or the state of the economy, but inflation. So will inflation cause Americans to finally embrace the “new normal,” stop spending and derail the recovery?

On Monday morning, the Bureau of Economic Analysis announced it’s monthly totals for February for personal income and expenditures. Both numbers were up and looked good. That was until you factored in inflation. The BEA releases its own measure of inflation called the Personal Consumption Expenditures Index. It is less well known than the popular Consumer Price Index, but some members of the Federal Reserve think it is a more accurate measure of inflation than the CPI. Well the PCE index rose 0.4% in February, that was the largest monthly increase for that figure in two and a half years.

The result is that when you adjust for inflation, personal income appears to be falling, down 1%. And that strong spending rebound we were seeing a few months ago? Well, again adjust for inflation, and that seems to be disappearing as well. Here’s what the popular economics blog Calculated Risk had to say (note when economists say “real” that means they are adjusting for inflation):

Even though PCE growth was at expectations, real PCE was low – and this suggests analysts will downgrade their forecasts for Q1 GDP. Using the two month estimate for PCE growth (averaging the growth of January and February over the first two months of the previous quarter) suggests PCE growth of around 1.4% in Q1 (down sharply from 4.0% in Q4).

So is inflation the thing that will get consumers to finally close their wallets? The thing is inflation is actually a two-edged sword when it comes to consumption. When inflation rises quickly, that can hurt confidence in the economy and as long as prices are rising faster than incomes (which usually happens when inflation really takes off) that can cause people to conserve their dollars. But if inflation is too low, that can hurt spending as well.

Here’s the thing: Inflation is part of recoveries. As the economy starts to grow faster, that boosts demand and with it prices tend to rise as well. This happens in every recovery. And it is a hump that every recovery has to get over. If prices start to rise faster than the economy, then recoveries fail. But that doesn’t usually happen. This time around the usually weak job growth has people concerned that rising prices will overtake the recovery. For now that doesn’t look likely. Even with February’s 0.4% jump in inflation as measured by the PCE, prices are still only up 1.6% in the past 12 months. (And that is actually less than the CPI’s jump in the past month of 2.1%.) Real GDP, by comparison, rose nearly 3% in 2010. So, for now, inflation seems unlikely to derail the recovery. But if prices continue to rise like they did in February we might have a problem. Stay tuned.