As interest rates have increased, mortgage payments, car payments, and other credit payments are now more expensive. This rise in everyday expenses has significantly affected consumer sentiment about the economy.
Economists have traditionally looked to unemployment and inflation rates to gauge consumer sentiment, but despite low unemployment and declining inflation, consumer sentiment remains subdued.
In the past, mortgage costs were included in the Consumer Price Index (CPI), as were car payments prior to 1998. However, modern price indexes no longer factor in borrowing costs. This oversight has resulted in a misrepresentation of the full impact of rising interest rates on consumer well-being, particularly when interest rates spiked last year.
This study demonstrates that the variation in the University of Michigan Index of Consumer Sentiment cannot be fully explained by official inflation and unemployment rates. Instead, it has historically shown a strong correlation with proxies for borrowing costs.
The survey's underlying questions also reveal that consumer concerns about borrowing costs have reached unprecedented levels, surpassed only by the era of Paul Volcker.
To address this discrepancy, alternative CPI measures have been developed that explicitly factor in borrowing costs. For instance, the CPI no longer just excludes mortgage costs but also personal interest payments, which increased by more than 50% in 2023.
By reconstructing the CPI of Okun's era, where inflation peaked at around 18% last year, we can account for 70% of the gap in consumer sentiment observed last year.
In conclusion, this study underscores the importance consumers attach to borrowing costs and highlights the potential for a significant improvement in consumer sentiment if interest rates were to decline.