Consumer Debt Takes a Holiday

Buyers are wary--but helped by refinancing

Will consumers finally tucker out in 2003? It's easy to see why they could. People are afraid for their jobs and worried about war, and the bear market has eroded their wealth. When times are tough, people tend to salt away money instead of spending it. "It's a no-brainer. People will not eat out as much. They will not [buy] the new car as quickly," argues Larry Howes, a partner in Sharkey, Howes & Javer, a Denver financial planning practice.

Still, it's too early to count out the tireless American shopper. True, consumer spending won't grow as quickly this year as during the boom of the late 1990s. There's a good chance it won't even grow at last year's robust rate of 3.1% after inflation. But growth in the 2.5% range is reasonable to expect, and that's pretty good in the face of so much bad news. Fueling spending will be continued low interest rates and low inflation, which preserves the real value of wages and salaries.

The latest numbers confirm that consumers are scared yet resilient. The University of Michigan's index of consumer sentiment fell in mid-February to a 9 1/2-year low. Yet people are buying a lot more than just duct tape, plastic sheets, and snow shovels. Retail sales excluding autos rose a healthy 1.3% in January, the most in two years. And on Feb. 19, the Commerce Dept. reported that construction started in January on 1.85 million homes--the highest rate of housing starts since 1986, and proof that homebuilders see unsatiated demand for housing.

Even before those better-than-expected numbers came out, economists surveyed by Blue Chip Economic Indicators predicted 2.6% real growth this year in spending. They estimate after-tax income will rise 3.1% after inflation--and most of the increased take-home pay will go toward goods and servi-ces. "Consumer spending cushions every single economic downturn," says Steven Wieting, a Citigroup (C ) senior economist. "You'll have weeks where consumer spending will retrench," but for the year it will grow, he says.

One of the biggest boosts to spending, of course, has come from the mortgage-refinancing boom. Refinancing reduces monthly payments, freeing up more money for spending. What's more, many homeowners have borrowed more than necessary to pay off their old mortgages. Some of the cash has gone directly into consumption and some has gone toward paying down debt that carries high interest rates, such as credit card balances. In fact, credit card debt fell $8.4 billion in December, the biggest decline in 27 years. Add it all up, and debt payments are only about 14% of disposable income, not much above the 13.5% average since 1980, notes Richard J. DeKaser, chief economist of National City Corp., a Cleveland banking company.

Spending in 2003 will be higher than in 2002 because of the improved household cash flow from mortgage refinancings completed this year and toward the end of last year. But the gains will diminish as the year goes on. Refinancings where cash is raised occur mainly when housing prices are rising and interest rates are falling, which is no longer the case, notes Jan Hatzius, a Goldman, Sachs & Co. economist. There are other factors working against consumers as well. Biting into wallets are high energy prices, especially among the poor, where they account for a bigger share of spending. A protracted war with Iraq would damage the economy. And pessimistic corporate executives continue to hold back on investment.

Still, American consumers seem wired to spend. At first glance, the Jan. 31 report that the personal savings rate jumped two-thirds last year to 3.9% from 2.3% seems like evidence of a Japanese-like retrenchment. After all, if spending rises less than income, it means consumers are choosing to save rather than spend. But the savings number is misleading because it excludes capital gains income. Such income dropped sharply in 2002 because of the bear market. As a result, incomes overall didn't rise as much as Commerce Dept. numbers indicate. According to an analysis by Federal Reserve Bank of New York economist Richard Peach, the share of overall income, including capital gains, that was saved edged up only a half-percentage point last year, vs. the 1.6 point gain by the narrower income measure.

Let's face it, American consumers aren't the kind to turn abruptly frugal. "When and if the economy picks up just a little, I think people will forget their fears and go right back to the habits we saw in the '80s and '90s," says Stuart A. Feldstein, president of SMR Research Corp., a Hackettstown (N.J.) consumer debt tracker. Spendthrift ways may be bad for long-term growth, but they're just what the economy needs today. And as long as Americans have a little spare cash hanging around, it's a safe bet they'll be laying it out, rather than stuffing it in a little piggy.

By Peter Coy in New York, with Faith Keenan in Boston

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