Are Consumer Blues a Clue to the Future?
By Christopher Farrell
Just how depressed are we? That question has a lot of policymakers very worried. Consumer confidence has taken its biggest hit since the '90-'91 recession. The Conference Board's Consumer Confidence index fell by 11% from December to January -- from 128.6 to 114.4. The consumer-expectations component for the coming six months plunged by even more, a stunning 20%. And the Federal Reserve Board largely justified its full percentage-point reduction in its benchmark interest rate in 2001 by highlighting flagging consumer confidence.
"What's disturbing is the rapid deterioration of the expectations component," says Lynn Franco, director of The Conference Board's Consumer Research Center in New York. Adds Richard Rippe, chief economist at Prudential Securities: "Consumers are more cautious than before, and if they become more cautious still, it will become a bigger problem."
All compelling reasons for Greenspan & Co. to be concerned. Still, most economists cast a wary eye on the notion that depressed consumers can talk their way into a recession. Yes, psychology matters. But in an economy as large and diverse as that of the U.S., the economic fundamentals carry much more weight. "The general conclusion among econometricians is that the consumer-confidence measures reflect what has happened in the economy, rather than what is ahead," says Meir Statman, finance professor at Santa Clara University. Adds Arthur Rolnick, director of research at the Federal Reserve Bank of Minneapolis: "I'm skeptical that consumer confidence is telling us much except what we already know -- that the last part of last year and so far this year was slow."
The great British economist John Maynard Keynes popularized the notion that the waning "animal spirits" of consumers could turn an economic slowdown into something far more ominous. Consumers account for two-thirds of economic activity, and when their mood turns dark, they spend less and save more. A vicious cycle can emerge, as frightened consumers rein in their spending, business sales decline, management lays off workers to shore up profit margins, job insecurity increases, consumers get more worried, and so on. The risk is that today's constant recession talk among Washington policymakers, Wall Street money mavens, the mass media, and others is turning into a self-fulfilling prophecy.
But let's take a look at how consumer confidence measured. The Conference Board (through the market-research firm NFO Worldwide) mails questionnaires to a random sample of 5,000 households, and about 70% respond. Consumers are asked five questions about business conditions, employment, and income. The answers are used to construct a composite consumer-confidence index, as well as several other indexes for assessing present and future economic conditions (). The other main gauge is the Consumer Sentiment index, put together by the University of Michigan's Survey Research Center. Its five questions are much broader and its sample size is 500 and the survey is conducted over the phone. The state of the labor market, especially jobs and income, is the main driver of consumer confidence.
These confidence measures are very much snapshots of the here-and-now. They seem to confirm what is happening to the economy, rather than predict what is coming. Economists haven't really unearthed a consistent, reliable relationship between consumer attitudes and future real economic activity. One intriguing exception is a 1998 paper by economists Jason Bram and Sydney Ludvigson of the Federal Reserve Bank of New York ("Does Consumer Confidence Forecast Household Expenditure? A Sentiment Index Horse Race," FRBNY Economic Policy Review, June, 1998, available at www.ny.frb.org). Their analysis suggests that The Conference Board indexes do contain information about the future path of consumer spending for several categories, including total personal-consumption expenditures and motor vehicles. The forecasting prowess of the University of Michigan survey was much weaker, however.
Nevertheless, most research suggests that consumer confidence tracks the rise and fall of the business cycle. No question, the steep erosion in consumer confidence did seem to lead into the 1990-91 recession. But Rippe notes that the decline mostly reflected the onset of the Persian Gulf War, the spike in oil prices, and the uncertainty surrounding how many American soldiers would die liberating Kuwait.
Today, it's hardly a surprise that consumer confidence has taken a decline with the weakening economy. But while the level of confidence may be down, it's not that down. Already, consumer spending seems to be moderating -- chain-store sales and auto sales were up in January. The Rust Belt is getting hammered, but nationwide incomes remain strong, and the labor market is tight. Anecdotal evidence suggests average working people are more optimistic than the discussion in Washington or Wall Street suggests. Even those Wall Street economists strongly in the recession camp believe the powerful combination of monetary easing and fiscal stimulus will improve the economy's performance later this year.
And what do consumers have to look forward to now? Lower interest rates. And maybe President George W. Bush's trillion-dollar-plus tax cut, that could be retroactive to Jan. 1. Consumers are bound to cheer lower interest rates and lower taxes. So there's no need to reach for the Prozac.
Consumer confidence index (1985=100)
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online
Edited by Douglas Harbrecht