Academic journal article Federal Reserve Bank of St. Louis Review

Does Consumer Sentiment Predict Regional Consumption?

Academic journal article Federal Reserve Bank of St. Louis Review

Does Consumer Sentiment Predict Regional Consumption?

Article excerpt

This paper tests the ability of consumer sentiment to predict retail spending at the state level. The results here suggest that, although there is a significant relationship between consumer sentiment measures and retail sales growth in several states, consumer sentiment exhibits only modest predictive power for future changes in retail spending. Measures of consumer sentiment, however, contain additional explanatory power beyond the information available in other indicators. By restricting attention to fluctuations in retail sales that occur at the business cycle frequency, the authors uncover a significant relationship between consumer sentiment and retail sales growth in many additional states. In light of these results, the authors conclude that the practical value of sentiment indices to forecast consumer spending at the state level is, at best, limited.

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Consumer sentiment is arguably the most cited indicator of current economic conditions, as it appears to be correlated with the strength of the economy. Following September 11, 2001, the two most common consumer sentiment indices--the University of Michigan's Index of Consumer Sentiment (ICS) and the Conference Board's Consumer Confidence Index (CCI)--fell an average of 20.9 percent through March 2003, reaching their lowest levels in nearly a decade. During the same period, real personal consumption expenditures grew by only 4.9 percent, compared with a 6.6 percent rate of growth over the two previous years when consumer sentiment was higher.

In fact, there is little argument in the academic literature that contemporaneous consumer sentiment and national consumption expenditure growth are related, as illustrated in Figure 1. Quarterly data since 1970 reveal an average correlation of 0.43 between real personal consumption expenditures and both sentiment indices. What has been an important and controversial issue in the literature is the ability of consumer sentiment to forecast future consumption expenditures. Given that consumption expenditures directly correspond with economic growth, the issue is, then, whether consumer sentiment can predict economic growth. If consumer sentiment does predict economic growth, a further question is whether consumer sentiment captures the perceptions of individuals directly or whether it encompasses the forecasting information contained in other variables. The answer to this question is of interest, given the timeliness with which the sentiment indices are released, often ahead of other indicators. (1)

[FIGURE 1 OMITTED]

Carroll, Fuhrer, and Wilcox (1994) find that lagged values of the ICS significantly explain nearly 14 percent of growth in real personal consumption expenditures. However, after including other forecasting variables in their models, the incremental impact of lagged sentiment falls to 3 percent. Bram and Ludvigson (1998) extend the models of Carroll, Fuhrer, and Wilcox [1994) by considering additional forecasting variables and the CCI in addition to the ICS. They find that the ICS is no longer a significant predictor of consumption expenditures when interest rate and equity price changes are included in the models. The CCI, however, did significantly improve the explanatory power of their forecasting models. This suggests that the CCI and the ICS do not provide the same forecasting information.

These mixed results are echoed in the ability of each sentiment index to forecast production and employment. Batchelor and Dua (1998) show that, in their model, the CCI is useful in predicting the 1991 recession, but their results cannot be generalized to other years. Matsusaka and Sbordone (1995) find that the ICS significantly improves their forecasting model for gross national product after considering other factors such as money growth, interest rates, and government spending. Howrey (2001) obtains a similar result for forecasts of gross domestic product. …

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