Some commentators continue to sound the recession siren based on the notion that higher interest rates and a weaker housing market will conspire to collapse consumer spending, drawing the current 16-quarter economic expansion to a close. Those expecting a sharp spending pullback have argued that 1) higher long-term interest rates will slow the residential real estate market enough to create a reverse wealth effect and crimp household spending; 2) higher energy prices finally will cut into household budgets enough to materially retard consumption; and 3) higher short-term interest rates will slow growth enough to restrain wages and stop consumers from spending.
I don’t think so.
Consumer spending is driven by income growth, which is the function of employment, the capital-to-labor ratio, productivity, and wage and salary rates. These trends remain sound. So we can expect consumer spending to expand at a respectable pace as long as income growth holds up, household net worth remains in positive year-to-year territory, and the level of real short-term interest rates doesn’t climb significantly above historical averages with respect to core inflation.
Consumer spending growth correlates most strongly with personal income growth, which has been remarkably strong. Hurricanes Katrina and Rita did temporarily distort readings on personal income, which slowed sharply during September before a snap-back in October. However, on an annual basis, personal incomes are up 6.3 percent while total compensation rose at a 6.9 percent pace (year on year) during the third quarter.
Strong trends in employment, productivity, and the capital-to-labor ratio should keep these trends in place — barring errant fiscal policy decisions in Washington.
While some of the more bumptious bears on Wall Street like to point out that low-end “cash wages” are not growing fast enough to support spending, I would note that the statistical linkage between income and spending drops by 12 percentage points, and the “error term” rises by 31 percent, when one substitutes non-supervisory production worker wages for the broader measure of personal income. Going through the same exercise with real variables instead of nominal ones only widens this divergence. In other words, broader measures of income are more closely associated with spending than more narrow measures; the use of low-end cash wages may be more useful when the point is political instead of economic.
While some regional housing markets could experience negative appreciation, I don’t expect a nationwide deflation in home prices, which is what would threaten the banking system, household net worth, and consumer spending. Even if you leave interest rates out of the equation, the ratio of average home prices to personal incomes is not out of whack with historical norms. In fact, despite rising off the lows of the 1990s, the ratio remains below historical averages. This doesn’t mean that the Fed’s excess liquidity of the past several years hasn’t seeped into certain local housing markets, where prices are indeed out of whack with the fundamentals. However, overheating in localized markets doesn’t add up to a national collapse.
If housing were to implode on a national basis, the banking system and the household sectors would no doubt come under serious strain. But this won’t occur unless the Fed takes the funds rate significantly above its historical norm relative to core inflation (this has occurred prior to periods of home-price weakness), or a fiscal blunder (such as raising the capital-gains tax) emanates from the stench of zero-sum politics in Washington.
There is no doubt that the rise in energy prices has placed pressure on low-wage consumers and those on fixed budgets. However, there has been no material pullback in broad-based consumption trends, which continue at a strong pace because of the underlying positive trends in employment and income growth.
Moreover, it is important to note that while energy consumption has risen by $225 billion since the end of 2001, total disposable incomes are up $1.5 trillion, corporate profits are up $361 billion, and household assets are up by an astonishing $12.2 trillion. Even if we exclude home values from the mix, total financial assets are up $5.3 trillion over the same period. In short, the rise in incomes, asset values, and profits has dwarfed the rise in energy consumption in absolute dollar terms.
The argument that there is no intrinsic savings in the U.S. also is a myth. Narrow measures of savings, such as the difference between personal income and personal spending, leave out many relevant household resources that could be tapped in times of need. Household net worth (total household assets less total household liabilities) has risen to a record $50 trillion. The ratio of financial assets (which excludes housing but not savings accounts or equities) is 3.6 times the level of personal income, slightly higher than the post WWI average of 3.2 times. What’s more, gross private savings, which includes both the household and corporate sectors, was 13.7 percent of GDP as of the second quarter (the last period for which data is available). While this is below historical norms, it is above the 13.6 percent average rate during the year 2000 when the U.S. enjoyed a fiscal surplus of 2.5 percent of GDP.
Lastly, total outstanding credit-market debt is off the 1990 peak with respect to total assets, which is an apples-to-apples comparison. Many countries (such as Japan) that have had high “savings” rates also have had asset deflation and no growth. The debt-and-savings time bomb is more of an urban legend than an economic reality.
Predictions of a near-term slump in consumer spending and even the potential for recession have become more widespread recently. But high-frequency data and recent financial-market action strongly suggest this won’t be the case. Domestic auto sales have been weak, but October same-store-sales beat expectations by more than 3-to-1 while the economically-sensitive Dow Jones Transportation Index reached all-time highs in recent days. These pro-growth trends suggest that today’s consumer is no dead man walking. So it’s still too soon to plan the funeral.
— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.