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Consumer Confidence and the Economy
From: University of Michigan
| By:
Richard T. Curtin |
EDITOR'S INTRODUCTION |
Consumer confidence is one of the most closely watched indicators of future economic trends. The latest figures on consumer sentiment are reported routinely in the press, incorporated into many macroeconomic forecast models, and included in the Index of Leading Economic  Indicators devised by the US Department of Commerce. In this feature Richard T. Curtin (right), director of the University of Michigan's Surveys of Consumers, discusses the roles that consumer expectations play in the economy and the increasing credence of the consumer in global economic theory and forecasting.
Since 1961, Surveys of Consumers, the economic research program at the University of Michigan's Survey Research Center, has collected monthly and quarterly data on consumer confidence, organized nationally and by region as well as by income and age. The surveys monitor consumers' personal, business, unemployment, government economic policy, price and interest rate expectations. |
 he economic research program at the Survey Research Center was started more than fifty years ago. Prior to the program's inception, most economists believed that consumers as a group had little influence over future economic trends. The conventional view held that businesses and the government shaped the direction of the economy and that consumers reacted passively to these forces. |
Today, there is little doubt that the consumer is the primary force shaping macroeconomic developments. Consumers now account for more than two-thirds of all spending in the United States, while businesses' investment expenditures and government spending together total less than one-third of the gross domestic product (GDP). |
As a result of the Surveys of Consumers' more than 50 years of published data on consumer expectations, the concept of consumer confidence is now part of popular culture. Consumer confidence levels are cited by government officials, business executives and the media, as well as by ordinary people, to describe national economic conditions. The surveys developed at the University of Michigan have been replicated in more than three dozen other countries. |
The Surveys of Consumers plays a unique role in shaping public policies as well as business decisions. This influence is based on the program's demonstrated ability to provide an accurate gauge of how consumers will react to changes in the economic environment. The surveys have long shown their ability to measure the various factors that shape consumers' decisions as well as provide timely information about their future intentions. Indeed, the Index of Consumer Expectations is an official component of the Index of Leading Economic Indicators--and the only component based on household surveys. |
What is consumer confidence?
To define "confidence" is to define its role in economic theory. When George Katona first developed the consumer confidence measure in the late 1940s, he did so as a means to directly incorporate empirical measures of expectations into models of spending and saving behavior. Katona summarized his views by saying that consumer spending depends on both their "ability and willingness to buy." By "spending," he meant discretionary purchases; by "ability," he meant the current income of consumers; and by "willingness," he meant consumers' assessments of their future income prospects. Katona hypothesized that spending would increase when people became optimistic, and precautionary saving would rise when they became pessimistic. |
Katona originally considered consumer confidence to be a broad measure of expected changes in income. It was not simply the expected size of a consumer's future income, but the certainty or uncertainty that was attached to those expectations. Thus, an important component of the definition of consumer confidence was that it encompassed both the expected level as well as the expected variance of income. To recognize this dual criterion, the dimension of consumer confidence was defined as ranging from optimism and confidence to pessimism and uncertainty. |
Survey measures
The Michigan surveys are based on nationally representative probability samples of private households in the contiguous United States. One adult in each household is selected at random to be the respondent. All interviews are conducted by phone from Ann Arbor by the professional staff at the Survey Research Center. Each household is interviewed twice, with the re-interview conducted six months after the initial interview, forming a rotating panel design. This design was selected to maximize the study of change in expectations, to provide a constant comparison of prior expectations with subsequent behaviors, and to avoid excessive attrition that could threaten the representativeness of the results. Each interview averages from 25 to 30 minutes, using a mix of closed- and open-ended questions designed in a conversational format, with the interviews spread rather evenly throughout each month. |
Powerful consumers
From the year 2000 to the present (mid-2002), the consumer sector has vividly demonstrated that it has the power to largely offset the unfavorable trends in business investment. Surprisingly, the actions of the business sector have displayed greater volatility than those of the consumer. Although continued consumer spending was not able to completely offset the current recession, it is likely to be the mildest recession on record. It is important to note that, despite their continued spending, consumers thought the economy was in recession long before it was officially announced. |
Why did consumers keep spending while at the same time expecting a recession? The 2001 decline in confidence was driven by a growing view among consumers that businesses were unwilling to invest in expansion and the creation of new jobs. Indeed, consumers' reports of rising unemployment recorded a larger increase in 2001 than in any other year since 1960. What made the declines in 2001 distinctive, however, was that they were accompanied by very favorable expectations about interest rates and inflation. Interest rate expectations posted more than twice the improvement recorded in any prior year, and inflation expectations fell to their lowest level in more than four decades. |
In a more fundamental sense, the issues faced recently are essentially similar to those that brought about the formation of the research program in 1945. The initial objective was to understand the role of the consumer in the transition from a wartime economy. Many feared that the post-WWII economy would give rise to the same type of deflationary spiral and mass unemployment that characterized the depression of the 1930s. Press headlines in mid-1945 proclaimed, "Government economists predict 8 million unemployed by 1946." What actually occurred was quite different. In the first half of 1946 the unemployed numbered 3, not 8, million, and instead of deflation, the economy faced very strong inflationary pressures. Unlike economists, consumers exhibited a great deal of confidence about the postwar economy. Acting on that confidence, consumers spent an increasing fraction of their incomes, as the savings rate plunged from 11.7 percent at the start of 1946 to just 2.2 percent by mid-1947--a low in the savings rate that would not again be recorded for 50 years. |
The remarkable performance of the economy since then would seem to suggest that the problems facing the post-WWII economy have all but disappeared. Unfortunately, this is not the case. In many ways the primary concerns about the national economy are remarkably similar. While fears of mass unemployment on the scale experienced in the 1930s were not present when the current expansion began, apprehensions about future job and income prospects were so widespread in the early 1990s that it was referred to as a "jobless" expansion. Concerns about inflation still dominated public policy considerations--with a twist. Fifty years ago policy was tilted against the possibility of renewed deflation (incorrectly, since inflation was the greater threat), while more recently policy was tilted against the possibility of renewed inflation (in the midst of strong disinflationary trends). |
The prominent role of savings is also similar. The proportion of income saved remained above the 1947 low for 50 years, but by the end of 1999 the savings rate recorded a new record low. At the start of the decades of the 1940s as well as 1990s, consumers were keenly aware of the inadequacy of their savings and reserve funds. To be sure, the concerns expressed by consumers in the 1990s were more focused on the inadequacy of their savings for retirement, whereas in the earlier period, short-term precautionary motives were more common. What is unchanged, however, is the important and sizable impacts on the macroeconomy that result from the influence those asset holdings have on consumers' economic decisions. |
In both periods the sizeable increases in wealth resulted from unusual circumstances rather than disciplined long-term savings plans. Just as the wartime restrictions on spending forced greater savings, the bull stock market of the late 1990s increased wealth through passive capital gains. The pace and extent of the restoration of savings were as unexpected as welcomed. While consumers hesitated to draw on their accumulated investments in both periods, they did not hesitate to spend a larger share of their current income. |
Many of the concerns from 50 years ago still apply to the current economy. Unlike the 1940s, however, there is now a substantial amount of data on the financial assets held by consumers, including the types, amounts and distribution across households. Such data still need to be supplemented by information on the attitudes and expectations of consumers to gain a more complete understanding of the potential impact on the macroeconomy. As an increasing share of the population nears and enters retirement, research on income expectations must focus on developments in financial markets as well as labor markets. Moreover, measures of expected risk and uncertainty must be broadened to include not only the health and disability of individuals, but also expected changes in private and public health and pension programs. |
Changes in the twenty-first century
Will the importance of consumer expectations as a force in shaping developments in the macroeconomy decline in the twenty-first century? While it is likely that in the twenty-first century recessions will be less frequent and less severe, it is highly unlikely that complete immunity will be achieved. While some of the past sources of instability may well disappear, the growing global interdependence of the US economy may elevate what were once minor impacts into more serious concerns for the domestic economy. Moreover, relative to declines in other potential sources, instabilities originating in the consumer sector, which accounts for two-thirds of all spending, may as a result become even more prominent. |
To a significant extent, the first half of the twenty-first century will still be shaped by the forces set in motion in the post-WWII era. The baby boom that followed WWII synchronized movements through the economic life cycle for an unusually large proportion of the population. It also synchronized shifts in how people assess their future economic prospects. Over the coming decades, the focus of the baby boom generation will shift from uncertainties about labor market conditions to risks originating in financial markets. To be sure, uncertainty about future rates of return on financial assets play an important role in consumers' assessments of their lifetime or permanent income regardless of their age. The relative importance of labor income, however, will fall as consumers near retirement and become increasingly dependent on realized returns on their accumulated financial assets. |
Precautionary savings theories focus on the impact of uncertainty about the future. Once sufficient wealth is accumulated during pre-retirement years, there is no need for such buffer-stocks of savings. Precautionary motives, however, will not disappear in retirement. Uncertainty about future real returns on assets will prompt consumers to engage in precautionary decreases in spending, in much the same manner that precautionary motives act to increase savings prior to retirement. Although uncertainty about future rates of return is incorporated into current theories of consumption, little is known about how consumers form expectations about future real rates of return, especially across their entire portfolio of asset holdings. Research on understanding how people assess uncertainty about future incomes must incorporate information on how people form expectations about future needs and how those expectations change as they age. Expectations about longevity and disability, as well as about in vivo transfers and bequests, will play an increasingly important role in shaping consumer behavior in the twenty-first century. In addition, expectations about changes in the provisions of private and public health and pension programs will need to be surveyed to fully understand how people assess potential future risks. |
Given that Social Security and other pension entitlements will represent a major share of incomes in the future, some have contended that there is little reason to expect income uncertainty during retirement to have a significant impact on the macroeconomy. By this same reasoning, it could also be argued that uncertainty about future labor income would not represent a significant problem since even at the worst of times the overwhelming majority remains employed. In addition, this line of reasoning ignores the potential impact of inflation; particularly changes in relative prices that are to the disadvantage of the elderly, since not all pension entitlements are fully indexed to inflation. Moreover, compared with variations in labor market conditions, valuations of financial assets are likely to exhibit more abrupt and relatively larger changes since shocks in global financial markets are more rapidly reflected in domestic financial markets than in domestic labor markets. To be sure, consumers do not react to every change in stock and bond prices, especially when their investment horizons are long. Little is known, however, about the thresholds or conditions which prompt changes in expectations about future rates of return, whether those factors operate in an asymmetric fashion, how time preferences and risk aversion change as people age, and what sources of information have the most influence on their assessments. |
Scientific advancement
Today the Surveys of Consumers research program faces as many challenges as opportunities for the scientific advancement in our understanding of the role of the consumer in shaping the macroeconomy. Despite the many changes in the economic environment as well as in the economic situation of consumers, there is no reason to expect the influence of the consumer on macroeconomic trends to wane in the twenty-first century. The strength of the research program is that it is based on the premise that the description and prediction of consumer behavior represent the best means to foster advances in theory. |
While there is nothing more useful than good theory, there is nothing more productive in generating theoretical advances than good data. The unique contributions of this research program will continue to be built on the collection of data that enable rigorous tests of established theory as well as allow the unexpected to emerge and energize new theoretical advances. Rather than being confined to the armchair of the theorist, the research program will continue to seek advances in understanding from the armchairs of respondents as they explain the factors underlying their economic decisions. |
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![[Richard Curtin]](3738_500.jpg)
