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U.S.: The Heroic Consumer: Down, but Not Out


Is the consumer spending machine running out of gas? One sign the tank may be close to "E" was the Federal Reserve's Beige Book, a regional survey of economic activity through Jan. 6, which said "reports on consumer spending were consistently weak." Another indication: The December employment report showed a sharp drop of 101,000 jobs, while the jobless rate remained at an eight-year high of 6%. These job trends--evidence that businesses are still not confident enough to start hiring again--are critical to the outlook because of two economic truths: Labor markets ultimately drive consumer spending, and consumer spending has been the linchpin of this recovery.

Thus, the outlook depends on nonlabor factors filling in the gap until hiring improves. It's a growing chasm, but one that can be bridged with help from expanding buying power, fiscal stimulus, mortgage refinancings, and the gradual, although volatile, recovery in the stock market.

The labor markets remain critical to the outlook and bear watching, but the positives for household finances still argue that consumers can keep this recovery going until the business sector kicks into gear. After all, despite sagging car sales, retail still grew fast enough in the fourth quarter to fuel a 1.5% to 2% annual rate of growth in real consumer spending (chart).

THE BIGGEST PLUS for consumers in 2003 will be continued income growth. Despite the loss of 181,000 jobs over the course of 2002, hourly wages rose by 3%. With inflation running below 2%, the buying power of the average paycheck is still expanding. Add in other earnings, such as salaries, interest, and government assistance, and it is likely that real disposable income will grow by 2.5% this year, a solid support under consumer shopping.

Another key positive are the tax proposals. Forget the debate over dividends. The bigger payoff to households will come from accelerating the tax-rate reductions, originally scheduled for 2004 and 2006, adding bigger child tax credits and ending the marriage penalty. According to James Glassman, economist at J.P. Morgan Chase & Co., these proposals cut personal taxes by $82 billion. The total impact of the package would be about $100 billion, which would lift economic growth by one percentage point from mid-2003 to the end of 2004.

The consumer outlook is also benefiting from the continued wave of mortgage refinancings. A survey by the Federal Reserve, published in the December, 2002, Federal Reserve Bulletin, studied refis done in 2001 and early 2002, prior to the record volume of activity in the second half of last year. The Fed economists found that lower mortgage rates enabled the average borrower to cut mortgage payments by $98 per month. Allowing for a slightly longer loan maturity bumped the monthly savings to $135.

The real boost to consumer spending, however, comes from the home equity tapped during a refi. The Fed study showed 45% of refinancers took money out of their homes, and those cashouts averaged $26,723 in 2001 and early 2002, up substantially from the $18,240 taken out in 1999. Borrowers used that money for a variety of purposes (table).

The study concludes that the refi-financed purchases added perhaps 0.5% to the annual growth rate of real consumer spending, and that home improvements lifted residential investment by 8.3%. Given that mortgage refis surged in the second half of 2002 and remained high into the first weeks of 2003, consumer spending should get help from refis this year as well, so consumers can continue to carry the recovery.

IT IS EQUALLY CLEAR, THOUGH, that the margin of error in the consumer outlook has narrowed considerably over the past year. The biggest uncertainty remains the growing geopolitical tensions. Possible war with Iraq is the largest overhang, followed by the nuclear standoff with North Korea, both of which are cutting into consumer confidence.

Plus, the Mideast turmoil and the strike in Venezuela are raising energy costs at a time when state governments are hiking taxes and fees to balance their budgets. Both trends will crimp household spending.

Global uncertainty is also hurting household spending because it is freezing the decision-making process among companies. That paralysis is holding back hiring and capital spending. Businesses' reluctance to add workers was clear in last month's employment report. Private payrolls fell by 115,000 workers in December, after a loss of 104,000 in November.

Almost all the December decline was in retail jobs, and that at least offers a glimmer of hope for January jobs. In the past two years, retailers added far fewer workers during the holiday season than they historically have. After the Labor Dept. seasonally adjusted the December numbers, the retail sector showed a huge job loss (chart). But retailers won't have to lay off as many workers this month. So the next labor report could show a large gain in retail payrolls. That's what occurred in January, 2002, when retail employment jumped by 78,000.

UNFORTUNATELY, MANUFACTURING JOBS won't stage a similar turnaround. They fell by 65,000 in December. But that's not necessarily a sign of weak factory activity. Goods-producers continue to use improved productivity and flexible working hours, rather than new hires, to increase output. In December, the factory workweek rose by 18 minutes, to 40.9 hours, and overtime edged up by 12 minutes, to 4.2 hours. Both were the highest readings since August. The longer workweek suggests industrial production increased last month for the second month in a row. That gain would echo the December rise in business activity reported by the nation's purchasing managers.

Although factory productivity probably did well in the fourth quarter, the same can't be said of overall output per hour worked. That's because the labor report showed a record rise in self-employed workers. This might reflect laid-off professionals who turned to consulting or free-lance work. The jump in self-employed workers increased the total number of hours worked in a quarter when output grew only modestly, probably holding back any gain in productivity in the fourth quarter.

But the favorable trend in productivity, which grew 5.6% in the year ended in the third quarter, means the 94% of workers still on the job will garner pay raises this year that outpace inflation.

Even so, the consumer outlook carries more risks now than at any time since the recession began. Expanding paychecks, along with a smaller tax bite, suggest that shoppers can keep spending this year, even if unemployment stays around 6%. But that's only if geopolitical risks don't cause the consumer

engine to stall out. By James C. Cooper & Kathleen Madigan


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