Economy becoming more 'susceptible to downward shocks' amid slowing growth: Economist

EY Chief Economist Greg Daco joins Yahoo Finance Live to discuss how the retail sales report will impact the economy, the services sector, and economic slowdown.

Video transcript

- Retail sales climbed 4/10 of a percent from March levels, but still falling short of Wall Street's estimates. How will this impact outlook-- well, how will this impact outlook for the broader economy? Greg Daco, who is the EY chief economist, joins us now. Greg, great to have you here with us this morning.

GREG DACO: Pleasure.

- You read through the data this morning and kind of industry by industry, or at least within the retail sectors, we should say, of purchasing for consumers, some of these same areas still showed weakness that we had already heard about in earnings seasons prior and even from some of the companies that are still set to report here. Is there anything that you extrapolate from this report and say that the economy is in a better or worse place because of it?

GREG DACO: I think just broadly speaking, first of all, it's important to understand that these data for retail sales are nominal data. So they are not adjusted for inflation. If you adjust for inflation, you're looking at a fairly soft picture when it comes to the US economy and the state of consumer spending.

We had a 0.4% gain in terms of nominal retail sales. But when you adjust for inflation, CPI rose about 0.4%. So that's zero, flat retail sales for the month of April.

Core retail sales, when you exclude some of the volatile items, rose, but they rose very lightly. And if you look at the year-over-year trend in terms of real retail sales, they're down about 3% on a year-over-year basis. So you're seeing people, essentially, being much more discrete when it comes to their outlays. They're still spending more dollars because things cost more. But they're buying fewer goods and fewer services.

- Are they buying fewer services, though, Greg? I mean, because these retail sales data don't include things like travel, right? They do include restaurants, food and drinking places. Those numbers went up, although I don't know what the inflation-adjusted numbers are. So how much of this can be explained by a shift in spend rather than an overall decrease in spend?

GREG DACO: Well, I think the shift in spend, the relative shift in spend is a story from 2022. We're really at the tail end of that shift in spending. The narrative that people are going out to restaurants and traveling more, really the bulk of that took place over the course of the past 12 months.

I'd be very curious to see how strong this travel season is going to be in a context where prices remain quite high. And, again, even in this report, you only had food services as a service sector reading. And that rose 0.6%. So adjusted for inflation, it's a very small month-over-month increase that you're seeing, even in the services sector.

So yes, people are spending more on services. You do have this environment where wealthier individuals have more means to spend. And they're still spending on some of the services sectors. But overall, there is discretion that is being applied, even in the services sector. The goods sector is seeing a significant pullback, the services sector less of a significant pullback, but much more discretion being applied in an environment of high prices and high interest rates.

- Well, even among some of the more wealthy consumers out there, I mean, I think back to some of the Conference Board data that we had seen about consumer confidence, and there's even been some moderation on the more affluent side of the consumer and where income levels are right now. So in that moderation and where that started to trickle through to either the services spending or even on the product spending side, does that spell out that if we see the more affluent or wealthier parts of the economy start to really pull back on spending, or at least put it elsewhere-- who knows where that might be on an investment basis, whatever the case may be-- how does that signal either a soft landing, a hard landing, or kind of a, I guess, a deeper recession?

GREG DACO: Well, I think, first of all, we're not seeing the type of traditional retrenchment that we see in the private sector whenever there is fear of a recession. You're not seeing any retrenchment in terms of business investment, in terms of the labor market, in terms of consumer spending.

What you are seeing is a cooling, more strategic decisions being made, and increased elasticity. So people are more sensitive to prices. And as prices continue to rise, there is more of that demand reaction than there had been in the prior two years. What that means in terms of spending going forward is that we are going to see this cooling.

What I'm fearful of is this environment where we're seeing growth gradually slow and the economy being more susceptible to downward shocks, whether it's the banking sector shock or the debt ceiling debacle that we're now going through. These are all increasing headwinds from a credit position, from a financial conditions position. Those are weighing on economic activity.

And an economy that is growing at a 1% pace is much more susceptible to these headwinds than an economy that would be growing at a 3% or 4% pace. And let's remember, the Fed is not tilting towards a more dovish stance. It will maintain a fairly tight stance going forward. So that's less of a tailwind than usual whenever you have a slowdown.

- That susceptibility that you're talking about, the delicacy, if you will, of the US economy, is that in the economy itself? Is that a markets susceptibility to these downward shocks? And when you say that there is this risk, how does that play out? What does that look like? What are the potential ramifications?

GREG DACO: Yeah, I mean, I think the risk is on both sides, right, on the economic side and on the financial market side. On the economic side, we know that the real economy is slowing. We have seen a slowdown in terms of employment. Initially it started with reduced hiring. Now we're seeing more and more layoffs. They're still not that significant relative to prior downturns, but we are seeing a softening of labor market trends.

We're seeing businesses being more cautious with their investment decisions. We're seeing consumers, again, being more discrete when it comes to their outlays and being more cautious as to how they spend their money. That type of environment leads to a slowdown in economic activity.

And then on the financial markets front, you still have a lot of concerns around the banking sector. You have a lot of concerns around what's happening with the debt ceiling in DC. And those are leading to a gradual tightening of financial conditions and credit conditions.

And we know how important credit is in the US economy. So if you have credit starting to tighten and financial conditions tightening at the same time, that generally leads to a further hit to the real economy. And that's how this interplay can lead to a more pronounced slowdown on the economic front.

- Greg, good to catch up with you this morning. Greg Daco, EY chief economist--

GREG DACO: Oh, it's a pleasure.

- --see you soon.