Income vs. expense shocks

If you are like me and like to look at long-term charts, you may have noticed something peculiar about consumer confidence. While the economy is arguably doing better than in 2008 and other major recessions, consumer confidence is so low, it can only be compared to the levels seen in the 1970s. Of course, the driver this time is inflation, not a decline in growth, but why does sentiment react so much stronger to inflation shocks than a regular recession?

Consumer sentiment in the US and the UK

Source: Bloomberg

I have no definite answer but research by Vance Larsen and his colleagues may give us a clue as to why that may be. Coming from a personal finance angle, they explored the reaction of people to unexpected increases in expenses vs. an unexpected decline in income.

In theory – and you all know what economic theory is worth, in my opinion – people should react to an unexpected expense of $2,000 the same way as to an unexpected decline in income of the same amount. Alas, when asking US citizens if they would be able to cope with an unexpected increase in expenses of $2,000 or if they would be able to cope with an unexpected drop in income of $2,000, their answers differed significantly. People reacted much more negatively to a decline in income than an increase in spending and the share of people who thinks they can cope with a $2,000 decline in income is significantly lower than for an unexpected expense of $2,000.

Share of people who say they can cope with an unexpected expense or decline in income

Source: Larsen et al. (2023)

The driver of this difference can be found in mental accounting. Faced with an unexpected increase in expenses, people mentally book this as a loss of gains. My income (=gains) remains the same, but I have to spend some of it on a specific item and have less for other things. Faced with an unexpected decline in income, people book this as a loss. Given the same amount of expenses that means they struggle to find alternative resources of income to make up for the shortfall and cover the regular expenses they face every day.

This is why losing your job is so mentally damaging. People who become unemployed lose an exorbitant amount of self-confidence and get scarred by these events for a long time. As someone who was at the wrong end of job cuts in his career, I have learned this the hard way. And I maintain that people who never lost their job or got into a financially difficult position can simply not understand the toll this takes.

A surprise increase in inflation has, in my view, the same effect. All of a sudden, you struggle to pay for the things you had no problem paying for in the past. Effectively, it feels as if you have lost a substantial part of your income and you have no idea how to cover the shortfall. If inflation increases in isolated areas like fuel prices, it doesn’t matter that much because it feels like filling up your car has become more expensive, but you can make up for it by saving on other things. If everything has become more expensive at the same time, where do you even start?

In a normal recession, people lose their jobs, and their income declines a lot and with it their confidence. But most people don’t lose their job and their confidence remains largely unchanged. When inflation rises, everybody’s income declines substantially, and consumer sentiment goes down the drain. And if what we know about becoming unemployed also holds true for a surprise increase in inflation, the recovery in consumer sentiment will take longer as well. Losing your income tends to be such a life-changing event that many people permanently change their behaviour and become more frugal. We will find out in the next few years if that is true in the case of an unexpected increase in inflation as well.