Higher gas prices are a potent force in affecting consumer spending, not so much because this occupies a huge portion of budgets, but because it drives consumer psychology, especially pertaining to inflation expectations and their real incomes.
According to the Bureau of Economic Analysis at the Department of Commerce, gasoline purchases in aggregate accounted for about 3.5% of total consumer spending, or about $350 billion in 2010. (Figures for 2011 are not yet available.) In 2008, when we had the oil price spike, gasoline purchases in aggregate were $410 billion vs. spending on gasoline of $335 billion in 2006 and $365 billion in 2007. To put this into perspective, aggregate consumer spending is roughly $10 trillion.
But it is a mistake to think that dollars spent on the pump will simply subtract from spending elsewhere on a dollar-for-dollar basis. If that were the case, rising gas prices would not be especially problematic given the size of gasoline purchases relative to household budgets, measured in aggregate.
What matters to consumer spending is how consumers perceive higher gas prices as affecting household budgets. Gas purchases are high frequency and the prices are widely advertised to any motorist driving on a city street. While I may buy spinach every week, I can't recall how much I pay for it since the prices are not posted on just about every corner, even though consumers spend more than twice as much on food as they do for gasoline, using aggregate data. Gas prices are an important framework in establishing consumers' worldviews, especially on inflation.
It is these inflation expectations where just one portion of household budgets becomes an outsized influence on overall behavior. I wrote about how consumers' spending patterns are tied to their expectations for wage growth and inflation. Right now, data from the BLS indicates that real (inflation-adjusted) wages last month were flat and in the past year real hourly earnings fell by 1% and real weekly earnings fell by 0.4%. This is not a new trend and consumers already expect low or negative real earnings growth.
While consumers may see an improving economy that might even cause their nominal wages to grow a bit, a rise in inflation that more than offsets that can cause their expectations for their real wages to fall.
Just prior to the spike in gas prices, consumers expected overall inflation to be 3.2% over the coming twelve months, according to the Thompson Reuters/University of Michigan Consumer Sentiment survey, compared with observed inflation in the consumer price index of 2.9% over the past 12 months. The rise in gas prices may skew these inflation expectations higher in the near term, which means that consumers will expect their after-inflation incomes to fall even further.
Recent research from the Chicago Fed shows that consumers expect their real incomes to fall by 2.5% over the coming 12 months. But that has been offset by a rising stock market, boosting wealth, even though housing prices have been generally flat or falling. Considering all of these factors, the research had suggested (prior to the surge in gas prices) that consumer spending would advance by just 0.1% in coming months, a low figure primarily due to the negative assessments for real income growth.
The research further details that real income expectations are the strongest predictor of consumer spending vs. wealth effects. Unless housing prices recover sharply or the market continues to rack up sizable gains, a rise in gas prices that cuts consumers' real income growth expectations can hurt spending. It doesn't really matter that much whether actual inflation comes in lower than what consumers expect. This was quite evident in 2008 when the rise in gas prices caused consumers to expect 6% inflation over the year, even though actual inflation that year fell by 1%. The damage was done for what consumers expected to be able to spend and, along with the drop in house prices and stock market wealth, consumer spending contracted sharply in 2008.
This time around, should we simply set aside the future direction of house prices and stock market values as unknown variables over the coming year, we will need to pay close attention to how the surge in gas prices affects how much consumers expect their real incomes to shrink or grow. That will help us determine whether consumer spending can be a headwind or a tailwind in the economic recovery.
