What causes a recession? Maybe it’s you and how grumpy you are about the economy
There’s been no shortage of doom and gloom predictions from Wall Street since the start of the year. From billionaire investors to former Federal Reserve officials, the list of experts predicting an impending recession seems to grow day by day.
Despite bright spots like another strong jobs report in May and an unemployment rate of just 3.6%, a “cost of living crisis,” stock market woes, and persistent recession predictions are wreaking havoc on Americans’ confidence in the economy.
More than 80% of Americans now believe the U.S. will fall into a recession in 2022, an April CNBC survey found. And consumer sentiment, as measured by the University of Michigan’s Consumer Sentiment Index, sank roughly 30% year over year last month, closing in on levels not seen since the Great Recession.
Most experts believe that Federal Reserve policy or macroeconomic woes like the war in Ukraine and sky-high inflation will be the cause of any potential recession. But some economists argue that consumers’ bad mood and increasing lack of faith in the economy—which is sometimes unrelated to their own financial reality—could in and of itself affect economic growth or even trigger a recession.
Peter Atwater, an adjunct professor of economics at William & Mary, told Fortune that if consumer sentiment continues to fall, it could cause Americans to pull back on their spending, leading to a sort of self-fulfilling recessionary prophecy.
“I am in the school that believes that how we feel drives what we do. And so sentiment, to me, is an indicator of what we are likely to do ahead, economically,” he said.
A vicious cycle
There’s a vicious cycle that takes place when consumer confidence falls, and Atwater says it typically begins with a period of overconfidence like what was seen during the run-up of the stock market and cryptocurrencies in 2020 and 2021.
“Recessions are almost always preceded by some level of overconfidence where we take on too much risk unknowingly,” he said. “And what happens then is we find ourselves feeling vulnerable when what we anticipated happening doesn’t begin to play out.”
That vulnerability manifests, according to Atwater, in a spending pullback, which then contributes to a recession, stoking even more fear.
To support this view, Atwater points to data from studies on the effects of Twitter users’ sentiment on stock prices. For example, in 2015, researchers at the IMT Institute for Advanced Studies found that there is a statistically significant “dependence between stock price returns and Twitter sentiment.”
“What you find is that within 24 to 48 hours, the mood on Twitter gets reflected in prices in the stock market,” he said. “This suggests that how we feel often precedes our actions.”
The chicken or the egg?
Of course, not every economist agrees that falling consumer confidence can spark a recession, and even Atwater admits that economists aren’t the best at “distinguishing chicken from egg.”
There is, however, evidence that consumer confidence can affect spending, which is a critical factor in the health of the American economy, as it represents roughly two-thirds of GDP.
In a 1994 study published by the American Economic Association, researchers concluded that “consumer sentiment does indeed forecast future changes in household spending.” However, they also argued that the predictive ability of consumer sentiment when it comes to the future path of the economy was “underwhelming.”
One of the authors of that study, Jeffrey Fuhrer, a senior fellow at the Harvard Kennedy School and the former executive vice president at the Federal Reserve Bank of Boston, told Fortune that he believes consumer sentiment is most often a reflection of the current economic situation rather than its cause.
“Sentiment is high when incomes, employment, and stock prices are high,” he said.
Still, Fuhrer says that fading consumer confidence can contribute to a slowdown in spending, which could at least exacerbate economic downturns. That idea is backed up by a 2020 study from the University of International Business and Economics in Beijing that found that “perceived financial vulnerability” does in fact have an effect on price-conscious behavior.
“I think it’s reasonable that in some circumstances, a pullback in business and household confidence plays a role in driving at least the depth of recessions, possibly the onset, but that’s a little harder to say,” he added.
Fuhrer also notes, however, that there are instances in which humans aren’t so reasonable. At some points throughout recent history, consumers and businesses have contracted “for reasons not readily linked to underlying fundamentals.”
‘Feelings of vulnerability’
Reading too much into consumers’ confidence levels, and how they can affect the economy, can be a dangerous game—particularly when there doesn’t seem to be a financial rhyme or reason for why they feel the way they do.
Looking at the Conference Board’s data on consumers’ expectations for the future of the economy compared with their current financial situation, it appears we could be at that stage now.
The Present Situation Index, which details consumers’ assessment of current business and labor market conditions, is at 149.6, higher than it was during most of the past decade. But the Expectations Index, which describes consumers’ short-term outlook for the economy, is at 77.5, below where it was during the pandemic, and the gap between these two key measures is at near-record levels.
This shows that consumers are fearful, despite relatively strong economic conditions, and that could drive an economic contraction. But there are all kinds of reasons that this gap might exist, and it may have more to do with politics than checking accounts.
“A lot of consumer sentiment today seems to be a function of political alignment,” Atwater said. “Individuals, when asked about the economy, are expressing more than just a view of their current economic or financial situation. They’re expressing love or hate with respect to who’s in the White House.”
Atwater believes that “feelings of vulnerability” are what ultimately drive consumer sentiment, and those feelings can be impacted by everything from political leanings to whether or not someone feels safe in their community.
But no matter the reason for falling consumer confidence, Atwater says, consumers’ pessimistic view of the economy could still increase the likelihood of a recession—and he’s seeing a lot of fear out there.
“There are a lot of people who are filling out these [consumer confidence] surveys, who are expressing low levels of confidence that we wouldn’t normally see in an environment of full employment,” he said. “And I think that speaks to an underlying malaise that is with us.”