U.S.: Consumers May Get a Second Wind in the Second Half

Cash from tax cuts and mortgage refis could offset job weakness

The job markets have always been the key driver of consumer spending. Given that, the news of more layoffs in May should suggest households are ready to throw in the towel. But perhaps not. Unique nonlabor events may trump the usual link between jobs and personal spending. If so, demand will be stronger in the second half than in the first, even if hiring remains weak.

So far this year, real consumer spending grew at an annual rate of only 2% in the first quarter, and second-quarter growth is running close to the same modest pace. But the first two quarters of 2003 will probably be the weakest half for consumer spending since the first half of 2001, when the economy slipped into recession.

Consumers will benefit from the coming tax cuts as well as this year's record wave of mortgage refinancings. In addition, household wealth has stopped shrinking, and the rallies in the financial markets, along with continued gains in home values, indicate net worth should increase in the second half.

Better household finances mean consumers could increase their spending at a rate closer to 3% in the third and fourth quarters. That would put a floor under growth in real gross domestic product, which will also get a boost from some pickup in capital spending.

But the economy's muscle will not necessarily trigger a burst in job growth or a significant slide in the jobless rate. And the sources of extra cash will widen the gap between wealthy consumers who earn money from investments and those who live paycheck to paycheck.

MAY'S EMPLOYMENT REPORT sketched out the problems in the labor market. Nonfarm payrolls fell by 17,000 last month, and the jobless rate edged up to a 9-year high of 6.1% (chart). Revisions made by the Labor Dept. show the recession generated more layoffs than first thought, suggesting that real GDP could end up looking a lot weaker during the recession than the government first calculated.

Factories continue to account for the bulk of job losses, with 53,000 pink slips handed out in May alone. The job cuts came despite signs from the nation's purchasers and data on orders that manufacturing output is set to rise soon. Private service companies added 37,000 in May, while the government shed 25,000. That was mostly at the state and local levels, where officials are struggling to close massive budget gaps.

With demand set to pick up, the worst of the layoffs are probably over. But even if real GDP growth speeds up to 3.5%, the economy is far away from generating the 250,000-to-400,000 monthly job gains common in the late 1990s. So wage increases won't return to their nearly 4% annual pace of the boom. And the jobless rate will probably edge up in coming months as workers who had dropped out of the market reenter the workforce hoping to find a job.

THE BATTERED STATE of the labor markets would typically send consumer spending into a tailspin. What argues against any pullback this time around is the money coming in from Washington, mortgage refis, and gains in household wealth.

Much has already been written about the boost to consumer spending from the changes in the tax treatment of dividends, reductions in the taxes withheld from paychecks, and rebate checks for qualifying parents. Altogether, these cuts will put some $30 billion back into consumers' wallets beginning in July. If it were all spent, that would add about 0.5 percentage points to real consumer purchases in the second half.

Layered on top of the Washington windfall is the money homeowners will save from refis. Fixed 30-year mortgage rates are hovering near 5%, and expectations of another Federal Reserve rate cut at the June 24-25 meeting is exerting more downward pressure on long-term interest rates. Consequently, homeowners are rushing to refinance. The Mortgage Bankers Assn.'s index of applications to refinance a mortgage hit a record 9,978 in late May and remained above 9,000 in early June. Refi madness now is greater than during the surges in 2001 and 2002 (chart).

Fannie Mae (FNM ) estimates that about 90% of all fixed-rate mortgages outstanding are "in the money" to be refinanced. Even if only three-fifths of those loans are reworked, the agency forecasts refi originations would hit a record $2.59 trillion, equal to the total amount of mortgages taken out for all of last year.

Also, Fannie Mae estimates that a "substantial" amount of money will be cashed out during the refis, giving consumers more cash to spend in the second half. Last year, $140 billion was liquefied through refis, and Fed research shows that consumers use the money to make home improvements, pay off existing debt, and buy other goods and services.

DESPITE THE SURGE in cash-outs, real estate remains the key source of household wealth. The Fed's June 5 report on the economy's balance sheets showed some good news on the household wealth front, and much of it was due to the hot housing market.

Household net worth -- total assets minus liabilities -- was virtually flat in the first quarter at $39.3 trillion, following a small gain in the fourth quarter. Rising home values helped real estate wealth rise by $18 billion to $7.7 trillion, even with a jump in mortgage borrowing.

The rise in real estate offsets declines in stock holdings and mutual funds (chart). But the recent increases in stock prices suggest that portfolios should show gains in coming quarters. If both real estate and equities advance in sync, the gains in household net worth would supply even more support to consumer spending.

Even so, the outlook for a better economy but poor job prospects could translate into a split in the consumer sector. Although income disparity is nothing new in the U.S., a more pronounced gap may emerge. The tax cuts are skewed to benefit households that earn income from stock investments as well as high wage-earners. Investors will also gain from the stock market rally, thanks to a healthier economy.

Consumers who rely solely on their paychecks will benefit to a lesser degree from the tax cuts, but they aren't likely to gain as much from the stock market or from the improving economy. Businesses will remain focused on generating output from increased productivity not from hiring. And with job growth subdued, pay raises will not return to their lofty levels of the late 1990s.

A recent survey by CEO group TEC International shows that 80% of chief executives expect the economy will be the most critical issue of next year's Presidential election, suggesting the split in consumer fortunes will play out in the political arena. The answer to the old campaign question, "Are you better off than you were four years ago?" may depend on whether you're part of the investor class or a paycheck consumer.

By James C. Cooper & Kathleen Madigan

    Before it's here, it's on the Bloomberg Terminal.