US consumers send stagflationary signals about the outlook

The latest University of Michigan survey of consumers is a stark example of the Trump-driven tension in the economic outlook faced by both the Federal Reserve and financial markets, with preliminary data for March showing a simultaneous slump in consumer sentiment and a further surge in inflation expectations.

Consumer sentiment provides only a very loose read on consumer spending and these are only early results, but confidence has fallen at a rate seen in past recessions, with a recession-like number of consumers now expecting higher unemployment over the coming year, while forecasting higher tariff-driven inflation over both the near and medium term.

As the university reported, “[surveyed] current economic conditions were little changed [in early March, but] expectations for the future deteriorated across multiple facets of the economy, including personal finances, labour markets, inflation, business conditions, and stock markets [and] many consumers cited the high level of uncertainty around policy and other economic factors”.

Estimating a simple probit model to calculate the current risk of recession based on the level of unemployment expectations, it puts the risk that the US has entered recession in early March at about 70%.

Like any of these sorts of models, the results are imperfect, as reflected in a pseudo-R-bar-squared of 0.4, although this estimate is well above the model's false signals of past decades, assuming, of course, that the extreme early March readings are sustained.

At the same time, consumers have abruptly raised their forecasts for inflation at all forecast horizons.

The expectations data are volatile, but 1-year expected inflation has increased from 2.8% at the end of last year to 4.9% in early March, which is the highest ex-COVID level since the global financial crisis.

The more important measure of 5-year expectations – which usually does not fluctuate much – has increased from 3.0% to 3.9% over the same period, which is the highest point since 1993, before the Federal Reserve unofficially adopted a 2% inflation target in 1996.

The Michigan survey results have been downplayed in some quarters because the responses from Democrats and Republicans are currently extraordinarily polarised, with Democrats much more worried about the outlook, factoring in higher tariff-driven inflation compared with Republicans expecting hardly any inflation.

However, the survey compilers report that the recent headline survey results are in line with responses from independents, such that the polarised responses from Democrats and Republicans are largely a wash on the survey’s findings.

Another uncertainty concerns a shift in how the survey is compiled, with the adoption of internet polling last year.

This could make the results less certain, although equivalent indicators from the New York Fed survey of consumers – which is based on a larger sample of households at a cost of less timely results – remain correlated with the Michigan data.

This is true even for consumer inflation expectations, where, as ex-Fed economist Claudia Sahm points out, little change in headline inflation expectations from the New York Fed’s latest survey simply reflects differences in how expectations are measured.

The Michigan survey reports the median of point forecasts of inflation over different horizons, while the New York Fed derives the median expected increase in inflation from the expected distribution of inflation over different time periods.

Usually, the two approaches give broadly the same answer on expected inflation, but sometimes, as the New York Fed acknowledges, they can be different.

As Sahm notes, the New York Fed also asks consumers to provide point estimates of forecast inflation and these showed a similar spike in 1-year expectations in February, albeit with little change in the 3- and 5-year ahead estimates.

The market’s reaction to this mix of expected economic weakness and higher forecast inflation is to factor in more rate cuts than the Fed anticipated at the end of last year, currently pricing in about three cuts by the end of 2025, one more than the median of two cuts expected by the FOMC in December.

This reaction works on the assumption that any economic weakness will take care of risks around inflation, where central banks normally react quickly to a deterioration in activity and the labour market.

However, there is the risk that the Fed’s hands may be tied by higher actual and expected inflation, where policy-makers would be worried that higher expected inflation could underpin high ongoing inflation in an echo of the 1970s, particularly when inflation is yet to return to the 2% target.

This means there is a distinct possibility that the Fed cuts by less than the market anticipates, keeping rates on hold for longer to see if the surge in expected inflation subsides.

The FOMC meets this week on 18-19 March and its updated economic outlook could reflect this possibility via upward revisions to median forecasts of the funds rate, inflation, and the unemployment rate.

The market does not seem to giving much, if any, any weight to this possibility, but a sense of it was apparent in last week’s policy press release from the Bank of Canada.

Admittedly, Canada already has a much lower policy rate than the US and faces much larger economic damage from tariffs, but it was still interesting to see the Bank of Canada stress that, “Monetary policy cannot offset the impacts of a trade war. What it can and must do is ensure that higher prices do not lead to ongoing inflation. [The] Governing Council will be carefully assessing the timing and strength of both the downward pressures on inflation from a weaker economy and the upward pressures on inflation from higher costs. The council will also be closely monitoring inflation expectations.”