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Is the US economy headed for a consumption shock??

We have all probably heard of the oil shock, but what is this consumption shock? The US economy was impacted by an oil shock, when OPEC increased oil prices in the 70s. OPEC’s move led to oil prices going up nearly four times, a move that slowed the wheels of the economy.

Well this time around, the US seems to be set for a consumption shock. Every economy has a key driver that propels its growth. For example, the Chinese economy is largely driven by exports and the Indian economy is based on knowledge led services. The key driver for the US economy is consumption expenditure. Nearly 70% of the US economy is consumption driven. Of late, there have been strong signals that consumers have begun to cut back expenses.

But what exactly is consumption and how does it impact spending? Consumption in economics is broadly defined as personal expenditure made towards the purchase of goods and services. Consumption-expenditure is made up of three components – income, savings and borrowed funds. The total of such household consumption expenditures gives us an idea of the total consumption or aggregate demand in the economy. In the current scenario of a recessionary US economy, all the three components of consumption expenditure are under squeeze.

  • Higher unemployment means less income and less for people to spend on consumption expenditure
  • Uncertainty of income means, people do not want to use their savings for consumption expenses
  • Earlier, rising home prices and borrowing against that had produced virtual home-ATMs; with the real estate market bust, these home-ATMs are gone leading to less consumption

The deceleration in consumer consumption was confirmed during the annual meet of the National Retail Federation (NRF) held earlier in January this year. The NRF has predicted that the retail industry sales will rise a mere 3.5% in 2008, the weakest growth in the last six years. The NRF president Tracy Mullin, in her opening speech, stated that spending was expected to dampen during the first half of this year.

The figures that were reported for January by the Commerce Department did not seem all that disheartening. The consumer spending reportedly rose by 0.4%, better than what economists expected. However, this growth, though appearing healthy was mainly due to an inflationary surge. This might sound a little complex, but may be simply understood based on the following example. The example assumes price change of a box of chocolates due to inflation and the impact on an assumed sale of 100 units of the product:

Text Box: Cost of a box of chocolates before impact of inflation = $4  Total sales = 100  Total consumer spending on this product = $400    Cost of box after inflation = $5  Total sales = 90  Total consumer spending on this product = $ 450    Actual post inflationary spending adjusted to inflation $4x90=$360    The example above assumes that the pre-inflation price of the product was $4 and the post-inflation price was $5. The rise in price should ordinarily lead to a reduction in consumption. Hence the example above assumes that the quantity consumed fell to 90 from the pre-inflationary sales of 100 units. Thus we can see that, while the total consumer spending has risen by around 12%, the quantity sold has actually come down by 10%. The real consumer spending adjusted to inflation is lower than the pre-inflationary spending. $360 < $400!!!


In reality, the 0.4% increase in consumer spending reported by the Commerce Department for the month of January 2008, once adjusted to inflation did not lead to any gains. That is not very heartening!

A close look at the figures released by the US Bureau of Economic Analysis reveal that there was no increase in real consumer spending in the months of December and January.

The news on the consumer spending front only seemed to be getting worse in February. The Reuters-University of Michigan survey on consumer sentiment plunged to 70.8 in February, which was the lowest in 16 years. In the previous month the figure stood at 78.4 making this dip really sharp.


The worsening consumer slump may be accelerated by another key factor that impacts the amount people can spend on consumption related expenses. A sudden spike in oil prices to $102 a barrel is likely to lead to higher gasoline prices from the current $3.16 per gallon to $4 per gallon. This will leave lesser money with consumers to spend on other items. Economists have projected that higher oil prices could siphon out about $90 billion from consumption expenditure. This does not seem to bode well from an economy already under the impact of a depressed housing market, rising unemployment and a huge credit squeeze. The slow down in consumer spending, which is a key driver for the US economy could pull it into a recession. Many believe that the US economy is already at the cusp of a recession.


Implications for the forex trader

A weakening economy is likely to mean that the Fed will try to prop it via interest rate cuts and other stimulus. A weakened economy is likely to exert a psychologically downward pressure on the dollar. Fed’s action of further interest rate cuts is also likely to keep the dollar weak. Thus, until the US economy starts showing signs of strengthening, the dollar is likely to display weakness.

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