Does Interest Rate Pain Explain the Consumer Sentiment Gap?

The apparent disconnect between the state of the US economy and voters’ perceptions of it has puzzled economists for months. Unemployment is low, inflation has come way down and real wages are no longer lagging behind. Yet consumer sentiment is still lower than you’d expect. A new paper offers a concise and persuasive explanation: “Consumers, unlike modern economists, consider the cost of money part of their cost of living.”

The authors are former Treasury Secretary Larry Summers (a paid contributor to Bloomberg TV), Karl Schulz and Judd Cramer of Harvard, and Marijn Bolhuis of the IMF. Summers’ contribution on this topic might raise some eyebrows. His recent record on inflation punditry has been mixed. He was right early on about the pressure of excess demand and the need to curb it; his characteristically confident judgment that unemployment would need to rise to get prices back under control has proved wrong (so far). The new paper isn’t punditry but a scholarly effort, and it seems to solve a mystery. Like most good answers, however, it raises further questions.

By now there’s quite a literature on “The economy is doing just great so why haven’t people caught on?” Economists are especially perplexed because they’ve long paid attention to the “misery index” – the inflation rate plus the rate of unemployment. This number is currently much lower than its long-term average. Yet consumer sentiment as measured by the University of Michigan’s polling, despite a recent improvement, is also lower than the long-term average. On the face of it, people are being gloomy for no objective reason.

What's the problem

Various explanations have been offered. The idea that people are too stupid to see what’s going on is popular (though usually phrased more politely). But other theories abound. Price increases have been skewed toward the costs of goods and services that loom large in the budgets of lower-income households. The level of prices, as opposed to their rate of increase, matters in its own right for those on fixed nominal incomes or otherwise coping with financial insecurity. Psychology might be a factor: After years of very low inflation had accustomed us to stable prices, we found the spike disproportionately unsettling. Perhaps dismay over America’s broken politics and dysfunctional government has so lowered national spirits that the malaise bled into the consumer-sentiment index. And so on.

Less Than Thrilled