Given the importance of consumer spending in the outlook for the economy and monetary policy, it's not surprising that Federal Reserve Chairman Alan Greenspan devoted a large chunk of time to the subject during his semiannual report to Congress on July 20 and 25. What was unexpected, especially to the financial markets, was the somewhat dovish tone of his remarks.
Wall Street had anticipated a more cautious message, but instead the Fed chief seemed optimistic, particularly with regard to his chief inflation concern: the widening disparity between the growth of demand and potential supply. The chairman appears to believe that the consumer-led slowdown of the last quarter will extend into the second half, even as productivity gains continue to support strong growth in potential supply.
This sanguine view shows up in the Fed's latest economic forecast (table). For 2000, the Fed's projection of economic growth centers on a range of 4% to 4.5%, with inflation picking up slightly to the range of 2.5% to 2.75% and unemployment ending the year at about 4%. For 2001, the Fed sees both growth and inflation slowing a bit, with unemployment holding about where it is now.
The forecast suggests two key conclusions about the Fed's thinking. First, the Fed may well stand pat, even if second-half growth is as high as 4.5%. Second, the Fed does not see the need to drive down economic growth so substantially as to raise the unemployment rate and loosen up the labor markets. The bottom line? Unless new data in coming weeks prove him wrong, Greenspan is likely to argue for holding interest rates steady at the Aug. 22 policy meeting.
GREENSPAN WAS CAREFUL to recognize the ongoing debate over the permanence of the second-quarter slowdown. And, in fact, the latest consumer-related data hardly suggest that consumers will keep scaling back their buying. So far, weekly surveys of July retail sales look strong, and consumer confidence in July rebounded. Plus, sales of previously owned homes in June also increased, to an annual rate of 5.23 million. The June level is above the record pace averaged during all of last year, and it is the highest since August, 1999. Home sales suggest that Fed rate hikes have had little impact on housing demand. Mortgage rates are actually down about 50 basis points since mid-May.
Greenspan, though, left little doubt about where he stands on the soft-landing issue. Prominent in his talk were "factors that may be exerting more persistent restraint on spending." He listed this year's flattening out in equity prices, households' rising debt burden, higher oil prices, and the already sharp runup in the stock of consumer durable assets, including houses.
Some of Greenspan's arguments, however, were less than compelling, and the point on consumer durables was downright confusing. On the wealth effect, for instance, his own measure, which relates the broad Wilshire index of 5,000 stocks to personal income, shows little--if any--diminution in the effect of wealth on spending (chart). Stock prices have picked up this summer, compared to this spring, on the belief that the Fed is almost finished with its tightening cycle, a view that Greenspan's remarks only supported further.
THE FED CHIEF'S CONCERN over debt burdens lies in the fact that household debt-service payments as a percentage of aftertax income have risen substantially over the past year, reflecting both the rising volume of outstanding debt and higher interest rates (chart, page 28). However, the combination of strong income growth and wealth gains has given consumers the increased capacity to take on more debt. Plus, the current level of debt service is still well below the peaks reached during the borrowing binge of the late 1980s, levels that at the time exerted no discernible downdraft on the growth in consumer spending.
Higher oil prices are probably the most restrictive factor mentioned by Greenspan. By his numbers, costlier oil has amounted to a $75 billion levy exacted by foreign oil producers on U.S. consumers, equivalent to a tax of 1% of aftertax income that cannot be spent on other items. However, even Greenspan noted that the effects may prove to be largely transitory.
The most curious observation that Greenspan made about restraints on consumer spending was that demand for durable goods and homes will wane because the past runup in the stock of these assets has left household demand close to a saturation point.
However, even a data hound like Greenspan is hard-pressed to find data that compares the stock of durables and homes to some desired level. And as long as fundamentals ranging from income growth to interest rates to wealth gains remain favorable, consumers have little reason not to buy a second house, a third car, or a fourth air conditioner. Indeed, Sears, Roebuck & Co. reported a 17% jump in second-quarter profits, led by sales of appliances and home electronics.
Economist Ian C. Shepherdson of the research firm High Frequency Economics calculates that the stock of houses and durable goods as a percentage of total household assets has fallen in recent years, reflecting the surge in stock prices. He adds that the growth in spending on houses and durables in this expansion has lagged behind overall economic growth. So, the recent speedup might simply be a period of catch-up as consumers feel increasingly upbeat about the economy.
BUOYED BY THE LOWEST unemployment levels in decades, strong income growth, and a booming stock market, consumer confidence remains very high. The Conference Board's index increased in July to 141.7, up from 139.2 in June. Households' expectations of future conditions rose in July, and their assessments of present conditions hit a record. That runs counter to Greenspan's arguments that high debt and energy prices are biting consumers in the wallet and will cause consumers to reduce their spending in a big or lasting way.
It seems more likely that much of the second-quarter slowdown in consumer spending and construction was simply a "payback" for the exaggerated first-quarter strength in home-building and car sales, which was largely the result of an unusually mild winter that "stole" some economic activity from the second quarter. Indeed, the drop-off in construction employment alone accounted for more than half of the slowdown in private-sector job growth between the first and second quarters.
All this is not to say that Greenspan's apparent optimism is totally unjustified. Clearly, more of the data are moving in the right direction now than three months ago. The crucial period for policy will be the months--and the data--immediately ahead. If the economic numbers heat up again, Greenspan's tone will surely become more strident, and market expectations will take a turn for the worse.