Are Consumers Finally Bending To The Will Of The Fed?

Consumers shopped and shopped last quarter, and now they've dropped. The question for the outlook is: Will they stay down? Or is the first-quarter lull in spending only a breather?

Since consumers are two-thirds of the economy, their spending behavior this spring will be crucial to the Federal Reserve's efforts to slow growth down to a noninflationary pace. If the first-quarter moderation continues, the chances for a soft landing rise, and no more interest-rate hikes may be needed. But if shoppers get their second wind, the Fed will tighten further--and risk squeezing the economy too hard.

The arguments that the weakness is only temporary range from fundamental to cosmic. Some analysts go so far as to blame weak spending on the "O.J. effect," as people stay home to watch the O.J. Simpson trial. A similar transitory lull accompanied the TV coverage of the Persian Gulf war.

A more down-to-earth argument: Income growth remains strong. Real aftertax income rose at an annual rate of 7.7% in the fourth quarter, and in January it began the first quarter by growing at a 3% annual clip.

Incomes appear set to outpace spending for the second quarter in a row. And if job growth rebounds from its weak January showing, sturdy income growth could pump up spending into the spring. One hint of that: Retail sales in the first week of March got off to a good start, according to the survey by the Johnson Redbook Service.

BUT AS JOHNNIE COCHRAN might say, it's not an open-and-shut case. For now, at least, the weight of the evidence is that the consumer sector is finally bending to the will of the central bank--with half of the Fed's past rate hikes yet to be fully felt in the economy.

The sales data and reports from retailers have looked weaker since Thanksgiving. Real consumer outlays for goods and services posted no gain in January, following a slim 0.1% increase in December. Although purchases of services and nondurable goods such as sweaters and restaurant meals rose, spending on credit-sensitive durable goods dropped 1.5%, the sharpest monthly decline in nearly two years.

Sales of cars, trucks, and parts accounted for most of the January weakness in durables. But even excluding that sector, buying of other big-ticket items still fell. Furniture sales declined for the first time in a year, a clear example of the effects of the housing slowdown.

Consumers' tepid start for the quarter means that real consumer spending began the quarter at an annual rate of only 1.1% above the fourth quarter. And in February, big retailers reported another month of soft sales, and car buying weakened. U.S.-made cars and light trucks sold at an annual rate of 12.7 million, down from 12.9 million in January. As a result, the Big Three carmakers have recently made further cuts in their output schedules for the first quarter.

All this means that first-quarter consumer spending will be hard-pressed to grow by half of the fourth quarter's robust 5% clip. That's why overall economic growth this quarter is slowing from its 4.6% gallop in the fourth quarter.

THE CONSUMER SLOWDOWN does have two benefits, however: Households are saving more and borrowing less (charts). The saving rate--personal savings as a percentage of aftertax income--has moved up in recent months, thanks to the strong income growth.

Some of that extra cushion may reflect job anxiety among consumers, as noted in the February consumer confidence report. Already, the trend in initial jobless claims is starting to move up a little. And in January, the Conference Board's index of help-wanted advertising fell sharply to 131 from 139 in December. Both tend to foreshadow movements in the labor markets.

Consumers may also be using the extra income to pay old bills. Wealthy households still face the second installment of the tax increase of 1994. And higher rates are placing an increasing drain on budgets, as the cost of variable-rate mortgages and installment debt adjusts upward.

Households added to their installment debt during last year at a pace that has not been seen since the debt explosion of the 1980s. But now, consumers are beginning to show more restraint. Installment debt grew by only $3.7 billion in January. That pace, down from $6.6 billion in December and from $13.2 billion in November, was the slowest seen in a year and a half.

One reason consumers are less willing to take on new debt: their heavy burden of existing obligations. Outstanding installment credit stood at 17.7% of disposable income in January, close to the peak level reached in 1989.

In addition, homeowners with adjustable-rate mortgages are digging deeper each month. For example, a 5%, 30-year loan of $100,000 that adjusts to 7% adds $125 to a household's monthly bills.

Some homeowners are struggling already. The Mortgage Bankers' Assn. reports that the delinquency rate on mortgages rose to 4.15% in the fourth quarter, from a 21-year low of 3.9% in the third. The MBA blamed higher ARM payments for the rise and projects that the uptrend will continue.

IN LIGHT OF higher mortgage rates and slower consumer spending in general, the resiliency of new-home sales is curious. New single-family homes sold in January at an annual rate of 679,000, up 3.8% from December. Although the data tend to be revised a lot, January's rate was not much different from the 676,000 sales pace of 1993--the best housing year since 1986. Indeed, new-home sales slipped very little in the past year, even though mortgage rates are up by more than two percentage points and the sales of existing homes have been falling since late 1993.

Consumers may be entering the new-home market by buying smaller or less luxurious houses, and by opting for adjustable-rate mortgages that typically lower the cost of monthly payments. The percentage of home buyers going the adjustable route climbed to 55% in December, compared to less than 20% in 1993.

Still, signs of a slowdown in housing are evident. For one thing, rising mortgage rates, both fixed and adjustable, mean more consumers cannot afford to buy a house. After rising in January, mortgage applications for the purchase of a home fell in February. And builders seem to have overestimated demand recently. Since November, the supply of unsold homes has stood at 6.4 months, the highest level since 1991 (chart). Excess inventory means builders will start fewer new units.

The decline in home construction, already apparent in the second half of 1994, will be more of a drag in 1995. At the same time, larger mortgage payments, burdensome credit-card bills, and higher taxes will leave less money for everything else that consumers may want to buy. And this new penny-pinching will pave the way to a slowdown in the overall economy this year.

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