Reply #48: Consumer Confidence Leads the Way

[54anickel]

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Friday’s advance release of GDP for the United States showed economic growth increased at an annual rate of 3.4% in the second quarter of this year. Although this figure was just shy of the consensus estimate of 3.5%, it continues to highlight the important role of the American consumer as a driving force for growth, not only in the US, but globally as well. Indeed, as the chart below illustrates, personal consumption has become an increasingly integral part of the US economy, accounting for over 70.1% of US GDP in the second quarter of this year.



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While businesses have always been interested in understanding their customers’ state-of-mind, it is interesting to note that since consumption began to account for a greater percent of GDP (starting in 1997), consumer confidence also seems to be having an effect on decisions made by the Federal Reserve as well. This fact is important because some may claim that it was greater openness by the FOMC in their policy statements that led to greater confidence of consumers as to the direction of interest rates, thus reversing the direction of influence we have heretofore established. However, it was not until August 2003, in which the Fed stated that interest rates would remain low for a “considerable period,” that the FOMC started to telegraph its future rate decisions. Therefore, it seems that it is the consumer, and not greater transparency by the Fed, that is the driving force. To that end, a look at overall consumer confidence (as defined by the average monthly value of both the Conference Board’s index and the University of Michigan’s index) reveals a strong correlation with the Fed Funds target rate, as indicated by the chart below in which we plotted the three month moving average – so as to smooth out volatility – against the Fed Funds rate.



Apart from the spike in confidence following the September 11th terrorist attacks, in which consumers made a concerted effort to rally together, the confidence (or lack thereof) of consumers and the decisions of the FOMC has been closely linked, with movements of the former often preceding those of the latter. The importance of this relationship is that, as The Economist noted, consumer confidence provides hints about the possibility of a recession and serves as a better indicator of downturns in the economy than the stock market. Therefore, keeping a close eye on the state of the American consumer may lead to a better understanding of the US economy, as well as any potential change in monetary policy from the Federal Reserve.

Of course, some critics will argue that it is the actual behavior of consumers that matters and not their attitudes. This is a valid concern, especially given the fact that many people, for example, often lament about the high price of gasoline as they are rushing out to buy yet another gas-guzzling SUV. However, a comparison of both consumer consumption and confidence shows a more cohesive unison in attitudes and behavior than anecdotal evidence belies.

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