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Consumers to play a supportive, not a leading role.

Consumers to Play a Supportive, Not Leading Role

CONSUMER SPENDING, the largest component of the economy, has grown over the years faster than the overall economy. Last year, consumer spending represented 65 percent of GNP, 5 1/2 percentage points above the level of twenty years ago. Consumer spending is also one of the economy's more stable sectors. In each of the past two decades, real spending grew at an average annual rate of 3 percent and spending declined in only two years.

The consumer has been an important factor in the current expansion. Sharp increases in consumer demand got the recovery underway and then provided enough momentum to keep it rolling. Between 1983 and 1986, real consumer expenditures rose at an average annual rate of 4 1/2 percent. The catalyst for these strong gains was a large rise in outlays for durable goods. Purchases of big-ticket items like cars, appliances and furniture had been postponed during the recessions of 1980 and 1982. As economic conditions improved, spending on durables took off, rising at an average annual rate of 11 percent between 1983 and 1986.

In the past two years, consumers' role in the economy has changed. Real consumer spending, instead of growing faster than real GNP, has lagged overall activity. A more subdued consumer is no longer acting as the economy's driving force; consumers remain, however, its underlying support.

Looking ahead, growth in spending will depend on consumers' ability as well as willingness to spend. The ability to spend will be determined by consumers' finances - especially their income. Consumers' inclination to spend will largely reflect their assessment of the economic environment. Although this is harder to quantify, it will be key to shaping consumer attitudes. Let's examine some of the economic variables that will determine the future course of consumer spending.


Having a job is probably number one on the list of factors that are important to consumers. Fortunately, employment has been very strong since late 1987. The large number of jobs created has been sparked by good domestic economic activity and growth in foreign demand. While the service industries accounted for the vast majority of new jobs, manufacturing employment also turned around from weak results recorded earlier in the expansion. The strength in employment helped reduce the unemployment rate to 5.0 percent in March 1989 - the lowest level in fifteen years.

The result of Federal Reserve actions to cool the economy, however, are becoming apparent. We anticipate that the slower pace of activity will also inhibit employment growth. More modest gains in U.S. exports and business capital expenditures will temper job gains in the period ahead. Even though smaller employment gains will be coupled with slower labor force growth, the unemployment rate is expected to move up slightly in the second half of 1989 and into 1990. It should average 5.2 percent this year and 5.6 percent next year. Although a rising unemployment rate could be unsettling to consumers, its relatively low level will help keep attitudes positive.

Employment trends are significant because more jobs mean more income for consumers. The resurgence in employment has pushed wages and salaries up sharply. In 1988, real wages rose by 4 percent in comparison to 2 3/4 percent in 1987. Wages and salaries influence spending the most because consumers tend to make purchases based on income they can count on week after week.

Two factors will affect wage gains this year and next. Slightly higher wage rates will be a positive influence on income. On the other hand, smaller employment gains will tend to keep increases modest. On balance, however, wage and salary gains will be less than last year.

Real disposable income, which includes all types of income such as interest, dividends and transfer payments adjusted for taxes and inflation, will moderate after a very strong first quarter increase of 7 3/4 percent. This sharp gain was due to a number of special factors, such as bonuses, payments to farmers and social security adjustments. Also, the boost to income from interest on investments will wane later this year as interest rates stabilize. Real disposable personal income is forecast to increase 4 percent in 1989 and 2 1/4 percent in 1990.

There is considerable debate over whether or not the increase in investment income adds to consumer spending. We think its impact is minimal. First, a portion of the increase in investment income is offset by rising interest payments on adjustable rate loans. Second, a large part of interest income is earned in accounts that are not liquid, e.g., IRAs and pensions. Finally, interest income generally accrues to older households, which tend to spend a smaller portion of their income than younger and middle-age families.


The key environmental factors that affect consumers every day are inflation and interest rates. Trends in these two areas are important because they impact spending directly via price changes and indirectly by affecting consumer confidence because they receive so much publicity. Consumers tend to adjust their spending to respond to price and interest rate changes. Good examples of this include the many successful sales promotions undertaken by retail stores and the low interest rate financing offered by auto manufacturers. Even though consumers are very responsive to price, they still don't view inflation as being out of control. Thus far, the evidence bears out consumers' perceptions. The all-item consumer price index experienced the same 4.4 percent gain in both 1987 and 1988. Furthermore, the underlying pace of inflation, as measured by the CPI excluding food and energy, has only accelerated a modest amount, from 4.2 percent in 1987 to 4.7 percent in 1988. (See Table 1.)

Table : Table I Consumer Prices
 Excl. Food
 All Items & Energy
 Year-end (%) (%)
1985 3.8 4.3
1986 1.1 3.8
1987 4.4 4.2
1988 4.4 4.7
March, 1989 5.0 4.7

Source: U.S. Department of Labor, Bureau of Labor Statistics

Inflation is being checked by a basic intolerance of rising prices by consumers, business and the Federal Reserve. As any retailer will tell you, consumers are showing a good deal of price sensitivity - hence the proliferation of "sales". Businesses' ability to raise prices is being limited by global competition, which keeps management focused on controlling costs. The Federal Reserve has demonstrated its resolve to fight inflation via tight monetary policy.

Inflationary pressures, evident in the acceleration in the CPI to a 5 percent rate in March, will persist through the year. The impact of last summer's drought and OPEC's agreement to restrict oil supplies will push up food and energy prices - at least temporarily. But, the key potential source of price pressure will come from strained productive capacity and a tight labor market. Wages have already moved up slightly. Higher wages typically affect consumer prices with a lag, because it takes some time for higher labor costs to be reflected in product prices. We expect consumer prices to edge higher this year before a slowing economy removes some of the price pressures. The CPI is forecast to rise, on average, 5 1/4 percent this year and 4 1/2 percent next year.

The Federal Reserve's action to blunt inflationary pressures has caused short-term interest rates to rise sharply. Short rates are 3 percentage points higher than at the beginning of 1988. Long-term rates have been relatively stable during the past year. Earlier inflationary expectations had caused them to climb in 1987. The slowdown in economic activity will allow interest rates to stabilize in the second half of 1989. In 1990, rates will begin to retrace some of their earlier increases as the economy develops some slack and inflationary pressures recede.


The last are to consider is consumers' financial position. During this expansion, consumers have been saving less and borrowing more. Personal savings fell from more than 7 percent of disposable income in the early 1980s to only 4 1/4 percent in 1988. At the same time, consumer installment debt outstanding rose from 14 percent of income to new highs. At the beginning of 1989, the ratio was at 18 1/4 percent. Although consumers' financial position won't be a plus to spending during the year ahead, we don't think it will impede consumer purchases.

Personal savings have lagged for a variety of reasons. First, at the start of the expansion, pent-up demand for goods led to spending increases that were well ahead of income gains. Then, traditional reasons to save such as for "a rainy day", financial security or retirement don't seem as compelling today. Demographic changes that put more people in their most spending-intensive age groups have also prompted spending at the expense of saving. Finally, consumers feel in relatively good financial shape. The long period of strong real estate prices and the threefold increase in the stock market since 1982 have significantly increased households' net worth.

The growth in consumer spending has been supported by a large increase in consumer installment debt. In an effort to put debt levels into better perspective, analysts like to look at the "debt ratio" - the relationship of installment debt outstanding to income. By this measure, we've been at historic highs for the past four years. If we include estimates of home equity loans outstanding, which became popular as a result of the Tax Reform Act of 1986, the debt burden looks even worse. Many analysts have cited debt-to-income excesses as a reason to expect a retrenchment in consumer spending.

We don't find this argument very compelling. The debt-to-income ratio does not go to the heart of the matter. It fails to signal exactly when debt levels become burdensome. And it also fails to recognize the structural changes that have taken place since the prior peak in the ratio a decade ago. Let me just list a few factors that help explain the increase in debt usage:

1. demographics: more people are in the most

credit intensive age group - 25-44 year olds.

2. acceptance: in the past decade, we've all become

more comfortable with running up

credit card balances and with the convenience

of using "plastic".

3. sales tool: preferred interest rates are frequently

used to sell products - most often


4. longer maturities: stretching out loan payments

lowers monthly carrying costs. The average

car loan today is 56 months vs. 45

months in 1983.

5. lower interest rates: home equity loans that

replace higher cost installment debt, preferred

interest rates on cars and more competition

among credit card issuers all work to

lower effective interest rates consumers pay.

And lower interest rates mean smaller carrying


A leading investment bank estimates that households' debt service requirements today are still well below prior peaks.(1) Consumers are apparently able to cope with their debt load. We believe that debt won't be the factor to constrain spending. The real risk is that if the economy turns down and consumer sentiment falls, high levels of debt could lengthen the time it takes for consumers to get their financial house in order. This factor could prolong an economic downturn should it occur.


The economy's resilience, continued growth in employment and income, moderate inflation, stable interest rates and a sound financial position will combine to keep consumers optimistic. The Conference Board's survey of consumer confidence shows that consumers' expectations for the economy are extremely positive with sentiment continuing near its nineteen year high.

Consumer spending would be expected to be robust except for two factors. First, after six years of solid spending increases, little pent-up demand for good remains. Second, higher interest rates will dampen consumer purchases of big-ticket items that typically involve financing. Housing and autos will be hurt by rising interest rates as they have been in the past. The Conference Board's survey of consumer confidence highlights the diverging trends in attitudes and spending intentions. In spite of exceptionally high levels of optimism, consumer intentions to purchase big-ticket items are below last year and more in line with results experienced in the less enthusiastic early 1987 period. (See Table 2.)

Table : Table 2 Consumer Confidence
 1 Qtr. 1 Qtr. 1 Qtr.
 89 88 87
Consumer Confidence Index
Present Situation 136.4 125.0 90.4
Expectations: 6 Mos. 105.8 104.2 91.4
Buying Plans Percent
Autos 7.4 8.8 7.6
Homes 3.0 4.5 3.9
Major Appliances 27.4 33.1 28.9

Source: The Conference Board Consumer Research Center, "Consumer

Confidence Survey."

We expect the moderate pace of consumer spending that has prevailed for the past two years to continue. Real consumer expenditures should advance 2 1/2 percent in 1989 and 2 percent in 1990. These gains will trail income growth, particularly in 1989. The slower pace of economic activity and a rising unemployment rate will create a more uncertain economic environment in 1990. As a result, consumers will increase their savings. Savings as a percent of disposable income will average 6 percent in 1990 vs. 4 1/4 percent in 1988.

The key factors that will moderate consumer spending - the lack of pent-up demand and higher interest rates - will have a greater impact on durable goods. Interest sensitive sectors will be vulnerable, with auto sales forecast to move down from 10.6 million units last year to 10.0 million in 1989 and 1990. Housing activity will also weaken with starts at 1.4 million units compared to 1.5 million last year. Real spending on durables will exhibit below average growth of 1 1/4 percent in 1989 and 3/4 percent in 1990.

Spending on nondurables and services will fare better than durables because they include more household necessities. Nondurables spending, which includes food, gasoline and clothing, will accelerate in 1989 after two years of poor results. Spending on apparel will lead the way, helped by moderate price increases and more appealing fashions. Real spending on nondurables will increase 2 percent in 1989 and 1 1/2 percent in 1990. Services, e.g., utilities, medical care and transportation, are the most stable component of consumer spending. Real expenditures on services are expected to continue to experience good gains, increasing 3 1/4 percent this year and 2 3/4 percent next year.


General merchandise sales includes retail sales of general merchandise, apparel specialty and furniture and home furnishing stores. Results in these stores (referred to as GAF) improved significantly in the fourth quarter of 1988, increasing at an 8 percent clip after five consecutive quarters of sluggish growth. The sales pace has moderated in early 1989; however, it's been difficult to get a true reading as unseasonable weather and an early Easter have distorted results. In any event, GAF sales are expected to slow by the important fourth quarter, reflecting modest economic activity and much tougher sales comparisons. For all of 1989, GAF sales will post a 6 percent gain or 2 3/4 percent adjusted for price. Next year, GAF sales growth will continue at a similar pace - 5 3/4 percent in current dollars and 2 3/4 percent after adjusting for inflation.

The sales momentum that apparel specialty stores began to generate late last year will carry over into 1989. There is pent-up demand for women's apparel - after being shunned by consumers for the past two years. The new styles are more in line with what women want. Also, clothing prices are pretty subdued when compared to the increases in the overall consumer price index. These positive factors, especially when compared to poor results in the first half of 1988, should produce good sales increases. Women's specialty store sales, in particular, will experience significant sales gains. As a group, apparel specialty stores will outperform GAF sales with a 7 3/4 percent increase in 1989. Next year, sales growth will moderate but remain slightly above average at 6 1/4 percent.

The performance of general merchandise stores should also improve compared to their lackluster 4 1/2 percent sales gain in 1988. Last year, discounters were the only store type in this category that posted strong results. Discounters, who historically have done well in a slow economy, should continue to thrive. The department stores and national chains, hurt by last year's weak apparel sales, will do better this year. Overall, general merchandise store sales are forecast to increase in line with the GAF average in both 1989 and 1990.

Furniture and home furnishing store sales will feel the impact of higher interest rates and slower housing activity. Merchandise related to housing, e.g., appliances, furniture and floor coverings, will slow. Also, home electronics, which has been a very strong category, will experience more moderate sales results. Sales at furniture and home furnishing stores will lag the other components of GAF with a 5 percent increase forecast for both years.


The expansion's maturity and the slower pace expected for economic activity indicate that consumer expenditures will advance modestly through 1990. Consumers will remain optimistic as the fundamental factors affecting attitudes will largely be positive. The increase in interest rates and the lack of significant pent-up demands will restrain sales of durable goods. After six years of solid spending gains, consumers will be supportive of an expanding economy, but other sectors such as business investment and U.S. exports will be the key engines of growth.


(1)Jason Benderly, "The Pocket Chartroom", Goldman Sachs. (*)Rosalind Wells is President, Wells & Associates, Inc., a consumer-focused economic research firm in New York, NY.
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Author:Wells, Rosalind
Publication:Business Economics
Date:Jul 1, 1989
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