The Unsinkable Consumer

Worries about inflation and rising rates haven't curbed the boom

The experts say the great American spending spree is winding down. With interest rates rising, the jobless rate up, and the Federal Reserve determined to slow growth, the handwriting seems to be on the wall. "The pie is going to quit growing," asserts David D. Glass, a director and recently retired CEO of Wal-Mart Stores Inc. Wall Street is so nervous that when Circuit City Group issued a mild profit warning on June 6, its stock fell 25%.

But don't be too sure the binge will turn to bust. There are many reasons to believe that consumers can and will keep on spending--maybe not at the white-hot rate of late 1999 and early 2000, but enough that the Fed will have to spend the rest of the year on guard against an upsurge in demand-induced inflation (pages 41 and 46).

Consumer spending is getting its strength from rising incomes, a rebound in the stock market, and robust consumer confidence. Total wage and salary payments to workers have been rising at an annual rate of over 7% in recent months before adjusting for inflation--about 4% in real terms. The Wilshire Total Market Index, the broadest measure of U.S. stock wealth, is up 9% from its April nadir and up 11% from where it was one year ago. And the Conference Board's index of consumer confidence in May was the second-highest ever recorded.

Talk to consumers and you see why predictions of a sharp decline in growth are most likely off-target. Ed Adelman, 50, a special education teacher at Lyman Memorial High School in Lebanon, Conn., says he, his wife, and his two sons are getting ready to take their most expensive vacation ever: a three-week, $7,000 trip this July to Britain and Ireland. Aside from losing his job, there's not much that could knock Adelman's spending plans off track. He says he doesn't own stocks, his mortgage rate is fixed, and he has no revolving credit-card debt. "I don't really know whether it would be good or bad for me if the Fed raised interest rates again," says Adelman.

In the first three months of this year, consumer spending grew at an annual rate of 7.5% after adjusting for inflation, vs. a sustainable rate of about 4%. For the rest of 2000, most forecasters are projecting a growth rate of between 3% and 4%. Of course, all bets are off if the Fed tries to drag the economy's expansion to below its maximum sustainable rate in order to let capacity catch up. And even in that scenario, Macroeconomic Advisers in St. Louis--with one of the lowest spending forecasts--predicts respectable 3.3% annual growth in the second quarter, 2.9% in the third, and 2.2% in the fourth.

While retailing is an obvious candidate for hard times if spending growth slows, many retailers seem optimistic. Says Pier 1 Imports Inc. CEO Marvin J. Girouard: "I'm really a little skeptical of the economists' projections and predictions. Our business is going to remain strong." He anticipates same-store sales increases of 5% in the second half--and predicts that if anyone gets hurt, it will be higher-priced retailers.

ECONOMIC DRAG. Housing is one of the few consumer sectors that is taking a real hit from higher interest rates. That pleases the Federal Reserve, which worries that rising home values have encouraged people to overspend. In April, sales of existing homes fell 6.2%, while sales of new single-family homes fell 5.8%. Says David F. Seiders, chief economist at the National Association of Home Builders: "In the coming months, the Fed wants housing to be a real drag on the economy, not just a slow-growth sector."

It could happen soon. Mark M. Zandi, chief economist at RFA Dismal Sciences in West Chester, Pa., estimates that homebuilding, purchases of home furnishings, and the wealth effect from rising real estate prices accounted for 26% of the increase in output in the first quarter. He predicts the contribution will drop to 11% in the second quarter. Housing's slowdown will subtract 11% from real GDP growth in the third quarter, and subtract another 33% in the fourth quarter, Zandi predicts.

But even if Zandi proves correct, the housing market is hardly going cold. Says Dennis R. Cronk, president of the National Association of Realtors: "It's important to keep in mind we're going from a superheated market to a very strong market." Says Ginny Holbert, a real estate agent for Prairie Shore Properties Inc. in Wilmette, Ill.: "Unless the interest rates go up to 12%, I don't see a really big impact if the economy in general is good."

CRUISING SPEED. Likewise with auto sales. They're down, but only from the fantastically high rate of the first months of 2000. "What we're seeing now is a blistering pace going to a robust pace," says Paul D. Ballew, General Motors Corp.'s director of market analysis. The blowout probably robbed sales that would have come later in the year. "America ran out of garage and driveway space," says automotive consultant Eric Noble, president of The Carlab in Santa Ana, Calif.

Most analysts still expect that this year's U.S. sales of cars and light trucks will slightly exceed the record of 16.9 million set last year. "Hot products are really driving demand and revenue growth," says Jacques A. Nasser, chief executive of Ford Motor Co., whose U.S. sales gained 1.4% in May. The one concern is that carmakers, led by GM and DaimlerChrysler, have had to lay on lots of incentives to move less popular models. U.S. marketing incentives climbed 33% in the past year to an average of $2,130 per vehicle in May, according to CNW Marketing/Research of Bandon, Ore.

For the economy as a whole, the bottom line is that, with the jobless rate still close to its lowest level in 30 years, consumers remain confident about their job prospects, so they don't mind spending. Says David A. Wyss, chief economist of Standard & Poor's DRI, a unit of Business Week's publisher, The McGraw-Hill Companies Inc.: "It's hard to see people doing anything un-American like actually saving money."

Unlike business investments, which can be highly volatile, consumer spending tends to rise at a fairly steady rate. Like a spinning flywheel, it has powerful momentum. The most likely cause of a significant drop-off in consumer spending would be a stock market collapse. S&P's DRI figures that stocks would have to fall 40% and stay down for nine months for the economy to fall into recession.

That's not impossible. Says Johns Hopkins University economist Christopher D. Carroll, a former Fed staff economist: "My view is that the stock market is really enormously overvalued. People underestimate the chance of a crash." As the recent market volatility shows, investors can change their minds in an instant. And a downturn in the stock market, by chilling consumer spending, could become self-reinforcing. "That's why economists die young," says Carl R. Tannenbaum, chief economist at LaSalle Bank in Chicago. "We have to be amateur psychologists as well as modelers."

Wary of messing with the minds of consumers and triggering a crash, the Fed generally moves cautiously. But when consumers are as enthusiastic as they've been lately, it could take substantially higher interest rates to slow them down. That's why the best guess is that consumer spending will keep the expansion alive for some time to come.

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