Retail sales may not be as bad as they look

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Earlier this week, we learned that spending at retail stores, online sites, and restaurants fell 1.1% in December after a similar decline in November. That could spell bad news for this year. When American consumers—whose total spending is almost 70% of GDP— pull back it’s hard to avoid a recession. But it’s not time for gloom and doom. These are encouraging signs on inflation, and the imbalances in the economy due to Covid and the war in Ukraine could be unwinding further.

Some of the declines are shifting back away from goods.

These new data are almost entirely spending on goods—with spending at restaurants. And during the pandemic, goods spending shot up relative to services spending: spending on goods—the portion measured from the retail sales survey—jumped from 25% of total consumer spending before Covid to 28%.¹ It has retraced some of that increase but remains at about 27% of total spending.

As things get ‘back to normal,’ it’s reasonable to expect a decline in goods spending (or a slower increase) than in services spending.² We will know more next week about services spending—which is still most of total spending—in December. That will give us a better sense of how much the retail sales data signal overall weakness versus a relative shift from goods back to services. It’s likely to be some of both, but the split is informative for the likelihood of a recession.

High inflation is the best cure for high inflation.

Businesses will keep raising prices as long as consumers are willing to pay them. A big drop in retail sales suggests that consumers may be reaching a limit. A more price-sensitive consumer is good news for inflation.

First, and most obviously, businesses will not be able to maintain the rapid price of last year's increases if consumers walk away. News reports suggest that several big companies are getting the message. Here’s one example:

Conagra Brands Inc., which makes Hunt’s ketchup and Slim Jim meat sticks, raised prices 17% in its latest quarter, on top of two previous quarters, when it increased prices more than 10%.

The company said it is done boosting prices for now. Conagra’s sales volumes fell 8.4% for the quarter ended Nov. 27, which the company attributed in part to shoppers recoiling from the price increases.

That anecdote also highlights an important lag in price setting. Businesses are not perfect forecasters of what people are willing to pay; they adjust prices based on sales outcomes. Big declines in retail sales at the end of last year, especially on the heels of large price increases, can help rein in future price increases. We are in a ‘race against the Fed’ and its rate hikes, so the faster consumers can wake up businesses, the better for everyone.

Second, the return of price-sensitive consumers is a comforting sign that an inflationary mentality is not setting in. If consumers are convinced that higher inflation is here to stay, they will expect higher inflation. That’s the ‘de-anchoring’ of inflation expectations that the Fed is afraid of.

Many retailers have more room to breathe.

We got even more good news on inflation this week. The increases in wholesale prices paid by producers, including retailers, have slowed notably. That puts less pressure on businesses to raise prices while maintaining their profit margins.

And about those margins, part of returning to normal will likely involve narrowing them. As Fed Vice Chair Brainard noted in a speech yesterday:

Retail markups in a number of sectors have seen material increases in what could be described as a price–price spiral, whereby final prices have risen by more than the increases in input prices.³ The compression of these markups as supply constraints ease, inventories rise, and demand cools could contribute to disinflationary pressures.

That’s not something retailers will do out of the goodness of their hearts, but consumers and competitive forces can get us there.

In closing.

The path back to low inflation continues to be a messy one. It’s not one the Fed controls. It’s about everyday decisions by consumers and businesses. We are seeing some of the imbalances in supply and demand of the past two years that led to high inflation start to unwind. Declines in retail sales, after years of outsized gains in both prices and goods, are a good sign for getting back to normal. And it’s a sign of how we are walking a tightrope of lower inflation, keeping jobs, and avoiding a recession.

1. In estimating consumer spending on goods in GDP, the Bureau of Economic Analysis only uses a portion of the retail sales data: total retail sales excluding gas stations, motor vehicle dealers, building supply stores, and other minor categories. The BEA makes a few more adjustments and creates the PCE control group.

2. The rapid rise in goods spending likely included a ‘pull forward’ of demand for purchases like washing machines, electronics, and home furnishings that are long-lasting. That dynamic would also cause a decline in goods spending. A reduction in spending on those categories could then be spent on other ones.

3. “Since the pandemic, significant supply and demand imbalances have coincided with large increases in retail trade margins in several sectors, increases that have exceeded the contemporaneous increase in wages paid to the workers in those sectors. For example, since the end of 2019, retail trade margins for food and grocery retailers increased by about 25 percent, outstripping the growth in average hourly earnings for workers in that sector, which was just under 19 percent. A similar gap exists between margin and wage increases for general merchandise retailers, which were 24 percent and 14 percent, respectively.”