Decisions, decisions, decisions: inflation and consumer preferences
Headline inflation might be on the way down, but it is declining very slowly in the US and the EU, and remains in double-digits in the UK. Much of the world has been living with elevated inflation for nearly two years now, and people are increasingly adjusting the way they spend money on goods and services (and invest) in response to higher prices. The fact is that increases in prices do not feel like they are moderating yet, even though the data might be suggesting otherwise. I believe that persistently high inflation is causing changes in consumption patterns. Moreover, to add insult to injury, once prices of goods and services increase, they are unlikely to decrease even as inflation slows. Rather, a new base will be established. Similarly, the change in consumption patterns are also unlikely to be reversed even when inflation settles back towards the coveted 2%/annum target. This article will drill down into consumption patterns and changes that I believe might be occurring because of higher prices, although admittedly, I lack anecdotal evidence. See what you think.
The inflation problem
In many parts of the world, prices of goods and services are increasing more than wages. Visual Capitalist wrote an article (here) for the World Economic Forum in early January containing the graphic below, which very much speaks to the price increases that were experienced in the US last year.
Similarly, a study on cost of living by the House of Lords (here) shows some of the food products with the highest price increases in the UK in 2022:
Both of this examples are representative of price increases being experienced in many parts of the world. For upper middle-income people and those better-off, inflation might be annoying but on the basis it will eventually be tamed is not soul-destroying. However, for many middle-income and lower-income people, inflation is undoubtedly extracting a serious amount of pain. These folks are increasingly being pushed to the edge, perhaps just barely able to scrape by because their expenditures tends to be mostly
non-discretionary, meaning that costs cannot be reduced because usage of these goods cannot be reduced. This graphic below from Investopedia shows certain expenses that might be classified as non-discretionary and affect one’s cost-of-living.
The effects of higher prices on those people that are struggling in this inflationary environment will likely have a deep and profound effect that extends to society at large, hard for those not in such dire straits to fully understand.
The direction of travel
The good news is that inflation is starting to come down in the US and EU/Eurozone, although it remains elevated in the UK. The bad news is that it is coming down much more slowly than desired, or – in other words – it is “sticky.”. The most recent reads for headline CPI in the US, the UK and Eurozone (March, YoY) were 5.6%, 10.1% and 5.7%, respectively. The graphs below show the direction of travel of inflation in the US, the UK and the Eurozone.
Changes in consumption patterns because of inflation
Are you finding that higher prices are causing you to look at what you are spending more carefully? Inflation seems to be everywhere these days, most noticeable perhaps with food prices at grocery stores. Annual renewal notices or subscriptions are a real eye-opener, too, with increases nearly always attributed to inflation. Isn’t it strange how many of the increases are well in excess of the inflation rate? Of course, it is difficult to dispute these assertions, but you can respond to price increases by changing your behaviour. In fact, higher prices of goods and services can motivate people to consider making decisions that they otherwise might not have even thought about in an environment when prices were more stable.
From a microeconomic theory perspective, whether or not price increases for a given product or service changes consumption patterns depends on the elasticity of demand. If demand for a product or service decreases as the price increases, then demand for the product or service is deemed elastic. Companies producing products and services with elastic demand curves might have a more difficult time increasing prices in line with increases in their cost base, because customers might reduce their usage of the product or service, or even stop their usage altogether. However, when demand for products and services is realtively inelastic, there is little that consumers can do to react in the short-run because the product or service is deemed essential. These include items like food staples, energy (heating, electricity, etc), housing costs including rents / mortgage payments, and so on. In reality, the demand curve of many products and services might lie somewhere in between.
I do not want to bore you with microeconomic theory, so let’s turn back to the practical realities as to how this period of unusually high inflation has affected consumer behaviour. Most people with whom I have spoken about inflation seem increasingly sensitive to rising prices regardless of their economic means. Below are some ways that inflation can affect consumer demand. As a follow-up, think about how these changes in consumption patterns might reverberate through to businesses, accentuating a potential economic slowdown.
How do consumers respond to higher prices?
Cancel / do without non-essential goods or services: Since people have less money to spend, the easiest and most effective “quick fix” would be to stop buying non-essential items or services. This is particularly true for products or services with elastic demand, where consumers are very price-conscience and can quickly dial-down demand in response to higher prices. Consumers might choose to:
travel long-haul less,
eat out less,
buy new clothes less frequently,
reduce cable TV / streaming / music services / other subscription services,
go to the cinema, plays or other entertainment events less frequently or not at all, or
quit their social club or gym.
Reducing costs associated with some of these things, or stop using them altogether, might not stroke your ego but they can make tremendous financial sense in this environment. Doing without certain non-essential goods and services is a real and immediate reaction to higher prices.
Substitution effect: Rather than doing entirely without, people might decide to “trade down” in terms of quality of goods or services. For example, they might decide to:
go to less expensive restaurants when they do go out to eat,
travel more frequently on budget airlines, travel in the back of the plane rather than the front, or do more “staycations” instead of travelling abroad,
buy less-expensive food items, substituting branded products for store-brands or white-labelled products,
work out at home rather than at a gym, or
buy non-branded rather than (more expensive) branded apparel.
I believe that these sorts of responses to higher prices– doing without things altogether, or in other cases substituting less expensive for more expensive products – are certainly occurring. The unfortunate thing for businesses, whether producing goods or providing services, is that these behaviours might prove difficult to reverse as inflation slows. Moreover,
even if you haven’t altered your behaviour yet along these lines due to price rises, you are probably looking at your expenses much more carefully. More careful watch over your budget is in any event a worthwhile exercise, noting that such scrutiny might not have occurred without there having been abnormally high inflation.
There is also an emotional element in that some price increases feel unjustified, almost predatory at times, and this can stoke a response even for those people that can easily afford higher prices. Addressing such expenses in this context can become a matter of principal.
For products with inelastic demand in which consumers have no choice but to swallow higher prices, there can still be adjustments to demand patterns albeit over longer periods. In other words, products with inelastic demand can see their demand become more elastic as time passes. For example, think about things like fuel consumption (heat or automobile). You might be able to curtail your usage at home modestly without freezing to death before improving insulation or sealing windows (to prevent droughts). You can choose to take less-expensive public transportation (or walk or cycle) to work, or you might even eventually buy a more fuel-efficient car. These might not be imminent decisions, but consciously or subconsciously, they will probably be considered.
From a broader economic perspective, a reduction in demand for products and services will reverberate through the broader economy, and not in a positive way. Even assuming that inflation is eventually brought down in line with the target level (2% for now), the excesses that have been wrung out of the system due to changing consumer behaviour and preferences will last much longer, essentially resetting demand for certain goods and services in the future. This will not be positive, especially in the US, since the consumer is the engine that drives economic growth.
 The most recent headline / core (non-food, non-energy) CPI reads: US (YoY, March), 5.0% headline / 5.6% core (BLS report here); Eurozone (YoY, March), 6.9% headline / 5.7% core (Eurostat report here); and UK (YoY, march) 10.1% headline / 6.2% core (ONSreport here).