>Households consumption: an economic heavyweight but the weakest link in US recovery (ECONOMIC RESEARCH)

■ The strength of the recovery taking shape in the United States depends on resilient household
consumption.

■ A review of the main determinants of this vital component of GDP, such as confidence, incomes, inflation, wealth and credit, nevertheless does not tell us with any certainty which forces will prevail in the play-off between cyclical support and structural curbs.

■ Our baseline scenario assumes that there is sufficient monetary and fiscal stimulus, along with pentup demand, to ensure that the nascent “technical” recovery is transformed into a lasting one. However, the recovery seems likely to be sluggish by US standards, as growth in consumption is hobbled by high unemployment, tight credit and households deleveraging.

According to the retail sales figures of the past three months, the recovery in household demand is less and less a mirage and more and more a real trend taking shape. The improvement follows a sharp, prolonged contraction in real consumption spending in the second half of 2008 followed by a stabilisation phase in the first half of 2009 made possible by the fiscal stimulus injected at that time, with lower taxes and higher transfer incomes. In Q3 of this year, the rebound in consumption (up an annualised 2.9% according to second estimates) is mainly due to the success of the “cash for clunkers” car scrappage scheme, but not entirely so. If we factor out cars and
gasoline, retail sales are also up, which is a sign that vehicles sales have not cannibalised other spending items and that the Q4 payback due to the expiry of the scrappage scheme should be softened.

What is there to drive a recovery in household consumption at a time when the US economy continues to destroy large numbers of jobs? While there is no doubt that the environment is scarcely favourable, what counts is the fact that the main determinants of consumption are gradually becoming less and less unfavourable, with rising consumer confidence levels, less job destruction, less and less stringent lending conditions, the dissipation of negative wealth effects, and low inflation(absent a new oil shock).

The conditions still exist, however, for an upward trend in the saving rate which, for a given income level, will hamper the recovery in consumption as households build up their precautionary savings in light of high unemployment (and the high budget deficit, assuming that some US households are Ricardians and thus increase today their saving to pay for higher taxes tomorrow), and with the lagged impact on wages of rising unemployment, the lagged impact of the collapse in personal wealth, plus the indirect impact of the elimination of leverage from Mortgage Equity Withdrawals and Home Equity Lines Of Credit, not to mention less abundant, less cheap credit and the process of shedding debt.

The confidence effect
As a leading indicator, confidence plays a key role in cyclical reversals, up or down. Confidence is also a capital that appreciates, runs out and reconstitutes itself. An upturn in confidence is a sign that the timeframe of economic agents (households and firms alike) is lengthening, and is favourable to more active spending behaviour. That said, it is an indicator of willingness, rather than capacity: if households do not have the means to fund their spending, their increased confidence will have a limited impact on their purchases. Currently, consumer confidence is no
longer at its lowest ebb due to the recovery in the equity markets and the fall in oil prices since their July 2008 peak. But recovery is still fairly tough going and the uptrend remains hesitant (the increase is not (yet) generating increases in a cumulative, self-sustaining process) due to the continued difficult conditions on the labour and credit markets.

Constraints on recovery
Our baseline scenario assumes that there is enough monetary and fiscal stimulus, along with pent-up demand, to ensure that the “technical” recovery we are seeing right now transforms into a lasting and selfsustaining recovery – in other words, to trigger a virtuous circle of supply and demand. However, this is likely to remain sluggish by American standards, as growth in consumption is being held back by high unemployment, tight credit and the necessary households deleveraging.

The income constraint
The deterioration in the labour market has put severe pressure on wage and salary disbursements (53% of the personal income), while the sharp rise in unemployment is prompting agents to build up their precautionary savings. And even if employment picks up in 2010, the lagged adjustment of wages to the unemployment rate means that wages will continue to be dragged down: the risk of wage deflation is not zero.

The wealth constraint
Between Q3 2007 and Q1 2009, just over 10 trillion dollars’ worth of financial wealth evaporated and between Q1 2007 and Q4 2009 around 4 trillion dollars’ worth of housing wealth followed suit. The negative effects of this severe, huge destruction of wealth will have a long-term adverse impact on household consumption, even if they are likely to dissipate gradually

In addition, the rebound in the equity markets since the trough of March this year (since when the S&P 500 has risen 42%) has put the dramatic erosion of their household wealth on hold. And since financial assets comprise 60% of total wealth, compared with 40% for housing assets, what is happening to the former is decisive, at least at the aggregate level. The big inequalities in the distribution of financial wealth mitigate the impact of stock prices fluctuations on consumption: the richest are not those with the highest propensity to consume. The estimates of the wealth effect are consistent with this observation: a 100-dollar drop in financial wealth results in a more moderate fall in consumption (of 3-5 dollars) than a similar drop in housing wealth (4- 9 dollars).

The credit restriction
We believe that the crisis is likely to make US households more conservative, frugal and risk averse. Their shedding of debt, partly forced and partly voluntary, looks set to be a long process so important do the past excesses to be purged appear. Yet it is quite difficult to measure the extent of those excesses, as they have to be measured against a yardstick that is very difficult to define: what is sustainable? A first criterion is debt service. This is falling but is still a long way from the previous peak of 12% reached in the mideighties. Low interest rates are undoubtedly contributing to keeping monthly payments under control. But if the fall is to continue, the stock of debt must be further reduced.

To read the full report: HOUSEHOLDS CONSUMPTION