Monday, April 07, 2003

Inflation: Is What we See What we Get

Morgan Stanley's Eric Chaney raises some interesting questions about whether perceived inflation affects consumer activity, and if it does, how this might help us understand the so-called 'teuro' effect. On the way he makes some depressing comments on the state of mind of the French consumer.

In two months time, French households' morale lost more ground than it did during the 1991 Gulf War. Categorised as assets in the European growth equation since 1997, French consumers are turning into liabilities. If this were only a swing of the growth pendulum across Europe, we would not care. But this is not the case. French are indeed catching up, or should I say catching down, with the European crowd, which already looked miserable. With European companies allocating their cash to debt repayment rather than to capital expenditure, with governments forbidden to press the fiscal pedal by EMU rules, there is no doubt that a downturn in consumer spending would put the region on a recession track. Against the consensus view of slow but positive growth in the second quarter, we have already priced in a GDP contraction, in the euro area at least (0.2%Q in Q2). Then, the question is, could be the correction be more serious -- I am afraid this could be the case -- and, more importantly, how long consumers will stay in the doldrums..................

Macroeconomists are supposed to be cold number crunchers, shielded from the real world by a wall of elasticities and multipliers, and I will play this role later on. However, we must not forget that the real world is made of human beings taking individual decisions. As far as consumers are concerned, decisions are based on their perception of current and future real income, but also on their perception of a wide set of risks, such as their job, their future pension or their wealth, but not only. Because layoffs are accelerating now, there is a risk that wage earners could suspect companies of using geopolitical tensions as a pretext for restructuring and thus raise precautionary savings if the war does not end soon. Unfortunately, quantifying the link between confidence and actual spending is not straightforward. Over the last 15 years, consumer confidence in the euro area and actual real spending show a modest 62% correlation. Nevertheless, a simple regression indicates that a 10-point fall in confidence is typically associated with a 1% cut in real consumer spending, which, other things being equal, implies a 0.5% cut in GDP. From Q3 2002 to date, confidence has dropped by 11 points. At 21, it now stands exactly 10 points below last year’s average. Since we expect consumer spending to grow 0.7% this year, after 0.5% last year, it is clear that even our gloomy forecast might err on the side of optimism if confidence does not improve in the coming months. In any case, second quarter consumer spending is likely to disappoint and I would not exclude an outright contraction in consumption and thus a deeper dip for GDP than the two tenths envisaged so far.

Since consumers were more sensitive to perceived inflation than to actual inflation when euro banknotes and coins arrived, they must have saved more than they would have done otherwise. Here are the maths. Using the high correlation between real spending and inflation, we have estimated that a one-percentage-point rise in the inflation rate typically cuts spending growth by 0.9 p.p. (since this coefficient is statistically not different from unity, it will be rounded to one in the following section). In fact, during the sampling period (1992-2002), consumers behaved as if their future income would not discount inflation changes and thus considered that gains or losses in current real income due inflation or disinflation were permanent. Until mid 2001, the link between real spending on the one hand and actual or perceived inflation on the other was the same, as consumers proved to have a very accurate perception of inflation. Then, price tags were switched from good old lire, D-marks or francs to strange euro numbers. Consumers quickly understood that something was wrong, especially in January-February 2002, when euro banknotes appeared. On our estimate, the "Teuro", as the new currency was dubbed in Germany, resulted in a 0.5-1% price increase (see "From Stag-flation to Stag-disinflation", December 5, 2002). On Eurostat estimates, it was only 0.3%. However, for Euroland consumers, the perceived rise of inflation was much larger. Using the excellent econometric relationship between actual and perceived inflation between 1992 and 2001, we reckon that, since the introduction of the euro, perceived inflation has averaged 4.6%, whereas actual inflation has been only 2.2%. This 2.3 p.p. gap between reality and perception is massive, in a low inflation world. However, for once, I see a positive aspect in this otherwise very negative story. Consumers must have continued to take their spending decisions based on their perception of inflation, not on actual inflation -- they do not believe in official numbers. Since they feel that inflation is 2.3 p.p. higher than it is in reality, they have refrained from spending by the same amount, given the unitary elasticity of consumption.

I am not talking about small numbers. The euro area generated €7,200 billion of value in 2002 GDP accounts, 58% of which went to consumer spending. Our calculations suggest that the optical inflation illusion generated by the euro resulted in an exceptional and temporary rise of Eurolanders' savings worth €95 billion (2.3%*58%*7,200). On our estimates, the personal saving rate increased from 14.7% of disposable income in 2001 to 15.5% in early 2003. This was at odds with traditional macro relationships. In the context of real disposable income slowing down, the natural shock absorber that is the savings rate should have decreased, not increased. Our analysis of the Teuro effect provides a credible explanation for this surprising event. Looking forward, consumers' misperception of inflation will not last forever, and the savings rate will come back to its "normal" level, freeing up at least two points of income. As always, this wealth now hidden in savings accounts will go to discretionary spending, mainly to big-ticket items such as cars and home equipment goods.
Source: Morgan Stanley Global Economic Forum

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