(By Robert Johnson, CFA) The highlight of the week turned out to be Federal Reserve chairman Ben Bernanke's comments suggesting that the economy might not be as strong as it looks, and that he would entertain additional easing measures if it performs worse than expected. Rather than panic over the potential weakness, stock and bond traders embraced the thought that more quantitative easing was in the cards and equity markets soared. Go figure.
Personal income and spending data late in the week suggested that consumers were on yet another buying binge even as inflation-adjusted incomes appeared to falter. My personal thought is that the income data has been exceptionally erratic and subject to large upward revisions. Meanwhile, the booming consumption number includes strong auto sales in February that benefited from the previous month's powerful auto sales that somehow didn't make it into January's consumption number. Every dollar of auto sales goes into the consumption number, even if those sales are financed for over five years, distorting the relation between consumption and income. So beware the economist proffering warnings that the consumer is running on fumes. As long as employment continues to grow, the income data eventually has to follow. More news on the job front next week.
Good News/Bad News From the Personal Income and Expenditure Report
The good news first: Consumer expenditures were up 0.8% sequentially in February, and January's figure was revised from 0.2% to 0.4%. Even after inflation, consumption growth was up 0.2% in January and 0.5% in February. I believe that at least some of that large month-to-month improvement was due to auto sales that looked soft in January according to government data, even as industry data was relatively strong in both months.
But what really got me excited about the month-to-month report was a large increase in the massive services sector that, heretofore, had improved at a glacial pace. I was especially pleased to see a strong services number because those dollars are spend primarily in the U.S., boosting the U.S. employment rate, unlike a lot of retail goods that are produced overseas. However, I should caution that even numbers this good are government data subject to revision, and it is just one month of dramatic improvement.
The consumption numbers were good enough to send economists back to the drawing board yet again for their first-quarter GDP estimate. First-quarter consumption now looks like it could be above 2% (and representing 70% of GDP), forcing many economists to boost their first quarter GDP growth estimates to 2.0%-2.5% from 1.0%-2.0% just two weeks ago. With only minimal improvement in March, the first quarter should show consumption growth of more than 2.3%, exceeding the fourth quarter's 2.1%. Our weekly retail sales report data has kept me on the right side of arguments concerning consumption growth. Remember, January growth according to the official government report was originally a big fat goose egg, which reminds us not to rely too much on any one data point.
Even as consumption numbers seemed unreasonably and inexplicably strong, income numbers were incredibly weak. Reported disposable income growth of 0.2% looked puny compared to spending growth of 0.8%. Things got even worse when adjusted for inflation. Income adjusted for inflation declined 0.1% in January and 0.2% in February.
So Why Is Spending So Far Ahead of Income?
I think at least part of the reason is that I believe the income numbers seem a little light given relatively strong employment growth. I think the relatively strong employment numbers versus meager wage growth (even before inflation) seems to indicate the potential for an upward revision. Also, real disposable incomes are being held back by taxes that are growing much faster than incomes. I surmise that many of these taxes are being paid by those that are better off, and the higher taxes aren't changing their spending habits, especially given the strong stock market. And some of the slow income growth is due to substantially smaller unemployment checks and Medicare and Medicaid payments, not entirely bad things (fewer unemployed, more people covered under work-related insurance, better health outcomes).
Finally as the use of credit increases, especially with a hot auto market, spending can move up without more income. The full cost of auto goes immediately into GDP and consumption while the cost can be financed over five years. Just as consumption fell dramatically faster than incomes at the beginning of the recession as credit contracted, consumption can go up faster than incomes as credit expand. Recent Fed data suggests that consumers have done just that.
Some observers fear that we are returning to our credit drunken ways. No way. I certainly don't want to return to a world where the only way to buy a car is with cash. By the way, in normal times when the proportion of people buying cars and using credit is at least relatively constant, one doesn't have to worry much about the mismatch between auto purchases, consumption, and income. But when auto sales increase more than 50% from the bottom and most of those cars are bought on credit, that is a big deal. In addition, the additional auto credit isn't coming from of crazed bankers but rational financial institutions. In retrospect, auto loans turned out to be a lot safer than mortgage loans (at least you could repossess a car and people tended to make their car payments ahead of mortgage payments).