How Will Consumers React to Moderating Inflation?

In the United States, data from various sources indicates that inflation is moderating from its 2022 highs. Consumers are also paying attention because inflation expectations are coming down. How will consumers change their behavior in response to moderating inflation? Many of us haven't encountered such high inflation, followed by its moderation in decades, and millennials and Gen-Z consumers haven't encountered it at all.

In this post, I want to consider how disrupted reference prices, the use of pricing structures by businesses to conceal price increases, and the role of buying cycles and purchase timing of consumers will affect their response to moderating inflation.

1) Consumers' internal reference prices have been disrupted by high inflation.

Throughout the 2000s and 2010s, prices increased relatively slowly and steadily, or not much at all. Take the case of the Subway $5 footlong sandwich promotion. Subway first launched this offer in 2003, and although it was withdrawn occasionally because of operators' complaints, it persisted through mid-2020.

When you can buy the same substantial lunch for nearly two decades for the same price, it becomes an entrenched price point. Not surprisingly, $5 became a significant internal reference price for lunch for many consumers. They could choose from different fast food combos and meals at the $5 price point for 20 years because of low inflation.

However, the $5 lunch is no longer available with the recent high inflation. Moreover, because prices are still increasing, consumers haven't been able to settle on a higher reference point they believe will stick. Lunch-buying decisions have become onerous because each option's price must be evaluated carefully. The same is true for other purchases.

When inflation moderates, it won't be easy to replace the entrenched $5 price point for lunch, the $400 price point for a car payment, or the $1,200 price point for rent. It's unlikely these price points are ever coming back. It will take a long time, of the order of years rather than months, for new price points to replace them, take hold, and influence our habitual buying behaviors.

2) Many sellers have shielded consumers from the direct price increases.

After the Covid pandemic, input costs have continued to increase for many products and services. Rather than simply pass on these costs to customers with across-the-board price increases, most sellers chose more subtle pricing strategies. They adopted a variety of methods to hide price increases.

Take the case of restaurants, which experienced large cost increases for virtually every ingredient, from bread flour to eggs to beef to vegetables. Within a short period, ingredient costs increased from 25-30 percent of the menu price to 40 percent or more for many restaurants. Labor costs also rose as it became harder to find workers to replace those who left for greener pastures during the pandemic.

As costs rose, restaurants used different indirect approaches to raise prices, such as shrinking portion sizes, substituting high-cost ingredients, reducing service levels, cutting down on price promotions, and reducing hours of operation. Many also added surcharges to bills, such as inflation surcharges, employee benefit charges, and living wage charges.

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For consumers, the upshot was that it became difficult to make sense of current prices, the logic behind them, and how they got here from their previous lower levels. Even more problematic is that the effects of this partitioning, or breaking up of the total price with surcharges, can be insidious. Research has found that consumers react more favorably when the prices are partitioned or itemized instead of given as a single aggregate amount because they underestimate the total amount. What's more, itemized prices appear to be transparent and confer goodwill to the seller.

All of this is to say that many sellers have shielded consumers from the direct effects of inflation by avoiding straightforward markups corresponding to inflation, but their strategies have hindered consumers' processes of sense-making and comprehension regarding prices.

3) Buying cycles and timing affect how consumers are impacted by inflation.

A third complicating factor is that while the reporting on inflation and consumer response is aggregate, its effects are individual and uneven. Thus, while average home prices went up by more than 20 percent in two years and used car prices went up by 40 percent, these numbers mean different things to different consumers.

Someone who purchased a house a few years ago and is locked into a 15-year fixed mortgage at around 2.1 percent won't care that the rate has risen to 7.25 percent. And used-car inflation won't affect someone who drives a paid-off car with no plans to buy another. Even if inflation comes down, most consumers won't buy a new house or car because they don't need these things. Housing and car inflation are irrelevant to them.

But it matters greatly to consumers who need to make a purchase. For consumers who must buy a house at an elevated price and pay the high mortgage rate, renew an apartment rental lease for 25 percent or 30 percent more than last year, or pay $30,000 for a used car, the effects will be significant, long-lasting, and affect their financial situation for years. This also applies to consumers making other big purchases using installment loans, like home improvement projects, graduate education, vacations, etc.

Conclusion

As consumers, our patterns of choosing, buying, and consuming are hard to change nimbly, even when external economic conditions change. They take time and cannot be hurried. This is because our buying behaviors are influenced heavily by routines, frequently rely on biased and incomplete information, and use simple and convenient heuristics for decision making. I've argued that the three factors have weakened the link between moderating inflation and consumer buying response. If and when inflation comes down and stays down, consumers' buying response will likely be slow, occurring over years rather than months.