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Weekly Economic Commentary


Soft employment conditions and household balance sheet repair continue to constrain consumer spending.

September 28, 2012

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• Soft employment conditions and household balance sheet repair continue to constrain consumer spending.
• This week’s readings on capital spending signaled a further retreat in business investment.
• Federal Reserve officials have begun to define what it will take to end the current program of quantitative easing.

I learned the concept of consumption in economics 101, but I didn’t fully understand it until I became a father and a homeowner.  Someone should really warn people about the annuity of expenses it takes to support these two habits.  Just this week, my son announced that he wants to go to a school that will cost more than $50,000 per year, and we learned that all of the gutters around the house need to be replaced.  My checkbook is going to need medical care.

I suppose that I can console myself with the knowledge that our expenditures help promote economic growth.  Personal consumption is about 71% of GDP in this country, and other countries rely on our consumption to fuel their exports.  So the financial health of American households is of keen interest to policy makers.

The latest news on this front, therefore, was discouraging.  Personal income eked out a small gain of 0.1% in August, after a similar increase in July.  After adjusting for taxes and inflation, real disposable income fell 0.3% in August and posted only a 0.1% gain in July.   

Chart 1

Dec 092812 Chart 1

Reflecting the absence of support from these soft income numbers, consumer spending slowed to a 0.1% pace in August compared with the strong increase of 0.4% in July.

Also of some concern was the decline of the US saving rate, to 3.7%.   Our view is that damage done to household balance sheets and retirement plans will necessitate an important increase in the saving rate in years ahead.  Consumption has been running ahead of income over the past year, a condition which cannot be long sustained.

A key to income growth, of course, is an improved job picture.  Restoring wages to those currently without them and improving compensation for those working would provide great support for spending.  But businesses appear reluctant to expand hiring until they see improved spending.  So we seem locked, for now, in a difficult chicken-or-egg situation.

Wealth and debt of households also bear strongly on spending.  As shown in the left-hand chart below, debt levels have been coming down since peaking in 2006, but may have some additional distance to decline.  Consumer credit continues to be used much more carefully; while modest increases have been seen in student and auto loans, mortgage debt continues to fall.

Chart 2

Dec 092812 Chart 2

Better news can be found in the right-hand chart, which shows that the net worth of households has recovered reasonably well since 2009.  The lion’s share of the improvement is due to the strength of equity markets; home values have only recently shown very modest gains.  This has likely kindled a bit of a renewed wealth effect; consumption will typically grow by three to five cents for every dollar increase in net worth.

These highlights of the household balance sheet indicate that a tremendous transformation has occurred in the last three years.  Although significant progress has been made, there are persistent obstacles which are a major source of concern.  Many households continue to confront an underwater mortgage situation (mortgage outstanding is greater than market value of home), and credit availability remains tight.  Deleveraging and strengthening of balance sheets should eventually leave households in a stronger position to support a more robust clip of consumer spending, but the process is far from complete.

My oldest recently floated the idea of returning to graduate school in the near future, pitching me on the idea of investing further in her human capital.  If this keeps up, my balance sheet, like my gutters, may be in need of significant repair.

Capital Spending: Global Concerns Prompt Deceleration

Capital spending was one of the components of strength when the recovery commenced three years ago.  However, incoming data raise concern.  New orders of durable goods plunged 13.2% in August, a staggering drop largely driven by aircraft orders.  Excluding transportation, durable goods orders posted a more muted decline of 1.6% and bookings of defense goods fell almost 28%.  

Chart 3

Dec 092812 Chart 3Dec 092812 Chart 3Dec 092812 Chart 3

The trend numbers of core orders and shipments of durable goods have been showing a decelerating trend during most of the year.  Core shipments data, a major input in the computation of equipment and software spending in the GDP report, suggest significantly soft readings for the third quarter. 

Non-financial businesses are cash rich and well capitalized, for the most part, which leaves us wondering about the factors that are driving the weakness of these numbers in recent months.  It appears that the EU crisis, uncertainty about the fiscal cliff, and slowing economic conditions in China are playing a role in holding back business spending.  This underlines the importance of getting clarity around such uncertainties, if we hope to see improved economic conditions next year.

What Will It Take to End QE III?

The Federal Open Market Committee (FOMC) took the novel step of tying its third round of quantitative easing directly to economic outcomes.  The statement following the September meeting said:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities…”

Since making that statement, market participants have been wondering what it will take to signal that the labor market is improving substantially.  Given the many measures of employment (a series of jobless rates, labor force participation, payroll levels, etc.), this is not easy to define.

Fed Presidents have begun to weigh in on this question.  Charles Evans of Chicago noted that sustained monthly job creation of more than 200,000 for some period would be key.  Evans has, in the past, promoted a regime where the Fed would adopt an informal unemployment target of 7%.

Naryana Kocherlakota of Minneapolis suggested that quantitative easing should continue until unemployment gets down to 5.5%, so long as inflation remains at 2.25% or below.

To us, the key word in the FOMC statement above is “outlook.”  It is probably not necessary for the unemployment rate to get all the way down to 5.5% or 6% before the Fed ceases bond purchases.  Some combination of meaningful progress and an expectation that trend will continue should be sufficient.

Among next week’s major news is the release of the September FOMC minutes on Thursday, which could reveal more background on what members define as substantial improvement for labor markets.  And we’ll get an updated look on those markets with Friday’s employment report from the Labor Department.  We’ll have coverage of both next week.



The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.