The Economy -- Mixed Messages

Dec. 21, 2004
Attitude indicators defy measures of economic health.

In January and February the expectations component of the Conference Board Index of consumer sentiment dropped at near-record rates, at the same time that the U.S. economy itself actually showed signs of recovery. How could that have happened? For one thing, the recent drop in consumer expectations has not been matched by a similar decline in real consumer spending, which continues to rise at almost a 3% annual rate. Some might argue that expectations lead consumer spending, but last year consumer spending started to slow down in the second quarter, well ahead of the plunge in consumer confidence. Most of the time this index is actually a lagging indicator. Nonetheless, the question still arises why expectations plunged so rapidly. In the past it was often thought that the misery index, the inflation rate plus the unemployment rate, was closely correlated with consumer confidence. Yet that is no longer the case; the misery index remains near a 30-year low in spite of the recent plunge in expectations. Many people now claim they fear being unable to find a job in the near future. While that may indeed be how they feel, it is difficult to believe that that sentiment has the same impact on consumer spending when the unemployment rate is 4.2% as it did when that rate was above 6%. What did cause the surprising decline in consumer expectations? The culprit is easy enough to identify; it is the stock market plunge and the fear that engenders. The drop in the S&P 500 over the last few months is closely correlated with consumer expectations; if the Nasdaq composite is considered, the plunge clearly would have been even greater. Previously I have mentioned that the impact of the stock market decline on the economy has been overstated by many economists. I still feel that way. However, even if this recent slide is important, it can be reversed very quickly, unlike changes in the unemployment and inflation rates. The unemployment rate is likely to continue rising throughout most of the year. Core inflation is not currently rising, but when it increased in the past it took at least a year to reduce that rate significantly. By comparison, the stock market could quickly turn around and rise rapidly almost any time. Furthermore, consumer spending continues to hold its own. While total consumer spending in real terms rose only 0.2% in January, that figure is somewhat misleading because there was a big drop in utility costs as the weather shifted from colder than usual in November and December to slightly milder than usual in January. Purchases of goods in constant dollars have risen at almost a 4% annual rate over the last two months. Thus the most recent economic data present starkly different pictures. The attitude variables -- consumer, housing, and business sentiment -- all have fallen sharply. In contrast, the variables that actually measure economic activity -- retail sales, purchases of consumer goods, new orders excluding aircraft, personal income, industrial production, and housing starts/building permits -- all rose sharply in January. The attitude indexes are lagging indicators, reflecting what happened in the recent past rather than what is likely to occur in the months ahead. Thus for the first two quarters of this year, I expect real GDP to advance at about a 2 1/2% annual rate before rising to almost a 6% growth rate by yearend. Housing starts will head higher, although they already took a big jump in January and might not rise again in February and March. Capital goods new orders excluding aircraft will continue to rebound, and shipments of capital goods will soon follow. Investment in high-tech goods will rise 10% to 15% this year, which is pretty good unless you were an investor who thought they would rise 50% per year forever. Although consumer spending will advance at more sluggish rates than it did early last year, it should continue to rise at about a 3% annual rate. Finally, because of slower domestic growth, net exports will stabilize for the next few months before declining again. Once the economy picks up, the lagging indicators of sentiment will suddenly improve again. Michael K. Evans is president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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