Why Has Consumer Confidence Suddenly Rebounded?

The relationship between consumer confidence and the economy's performance has been a subject of intense discussion within financial markets over the past year. Why has consumer confidence been so weak while the U.S. economy appears to have expanded by 2.5% in 2023, with an unemployment rate near 50-year lows? The only logical explanation is that consumers have been upset with high inflation readings that have prevented them from maintaining their standard of living.

While no one seriously believes that prices will return to pre-pandemic levels, since inflation often moves higher and rarely registers negative readings, the fast pace of price increases is probably largely behind us!

Consumers realize that the U.S. Federal Reserve has vowed to bring inflation down from its current +3.3% yearly growth pace to +2.0% or lower. As that happens, consumer sentiment is likely to move even higher from its current levels. Meanwhile, the pace of real GDP growth is likely to slow from 2.5% in 2023 to about +1.5% in 2024 which should push consumer sentiment in the opposite direction.

Consumer Prices and the University of Michigan Sentiment Index

Our analysis reveals a negative correlation between the yearly rise in consumer prices and consumer sentiment. This was observed as consumer sentiment hit a low in June 2022 as consumer prices rose to their highest annual gain since the onset of the global pandemic! As the inflation rate has fallen, consumer sentiment has been creeping higher, as seen by the 29% jump in sentiment in January 2024 from its November 2023 readings!

Digging deeper into the numbers, our statistical analysis revealed that for every 1.0 percent decline in the CPI, the Consumer Sentiment Index tends to rise by 2.2 points. This indicates a clear inverse relationship, highlighting the impact of inflationary pressures on consumer confidence.

Source: The U.S. Bureau of Labor Statistics and The University of Michigan, Consumer Survey

Still, other factors might dampen consumer confidence (e.g., a slower growth outlook for 2024 and geopolitical uncertainty). Still, our analysis suggests the consumer sentiment index, which registered an impressive rise over the last two months, should be even higher today, given the drop in inflation from its peak!

Although we have been frequently reminded that “it’s the economy, stupid,” and nothing else matters, consumers can hardly ignore that the world is grappling with several wars simultaneously and that global supply chains are once again being threatened because of these conflicts. If any of these factors escalate, it will mean additional upside risks to inflation, which is the archenemy of consumer confidence!

Summary and Concluding Thoughts

The relationship between the University of Michigan Consumer Sentiment Index and the year-over-year rise in the Consumer Price Index underscores the impact of inflationary pressures on consumer sentiment. Although other factors are at play, the effects of inflation play a dominant role in determining the state of consumer sentiment.

The recent remarkable rebound in consumer confidence, which has risen 29% since November 2023, suggests consumers are gradually shedding the pessimism that dominated our economic landscape over the last few years.

Our nonpartisan analysis will leave it to the reader to decide which political party is best positioned to address the other factors, keeping the Consumer Sentiment Index as much as 7.0 points below the reading implied by our regression analysis.

As one can see there are many factors that can impact consumer sentiment, but at the end of the day, one of the most important factors is the underlying inflation rate. In the meantime, investors should continue to monitor the other variables that can also impact consumer sentiment!