Academic journal article Economic Inquiry

Consumer Confidence and Economic Fluctuations

Academic journal article Economic Inquiry

Consumer Confidence and Economic Fluctuations

Article excerpt


The idea that consumer sentiment might cause output fluctuations is popular in the business press.(1) It is easy to see where this belief comes from: in Figure 1 we plot an index of consumer sentiment against recessions for the postwar period.(2) The pattern is striking; all recessions were preceded by a fall in confidence, and all major falls in consumer sentiment were followed by a recession (except in 1965 which, while not a recession, was the so-called "growth recession"). Apparently either consumers were correctly forecasting output falls, or declines in consumer sentiment were inducing declines in output.

It has been recognized for some time that business cycle and growth models can exhibit multiple (Nash) equilibria if they contain strategic complementarities.(3) In a conventional single-equilibrium model, output fluctuates only in response to changes in economic fundamentals, where the list of fundamentals includes technology, government purchases, money supply, the price of oil, and so on. In a multiple-equilibria model output responds to fundamentals, but in addition there can be fluctuations as the economy shifts between equilibria. Perhaps the most intriguing feature of these models is that output can fluctuate simply because everyone expects it to. Put differently, expectations can be Self-fulfilling in that if people expect bad times they get them. Thus, this class of models offers a theoretical rationalization of how consumer sentiment can affect GNP. Although these models introduce dramatically different policy considerations than single-equilibrium models, many of their observable implications are the same. As a result, their empirical relevance is largely unknown.

In this paper, we study the behavior of the U.S. economy for the period 1953-1988. Our central purpose is to evaluate empirically how much truth there is, if any, to the idea that consumer sentiment causes fluctuations in GNP. Following Granger and others we take causality to imply temporal precedence, that is, if one series causes another, then movements in the forcing series precede movements in the forced series. We verify that the temporal ordering suggested in Figure 1, consumer sentiment leads GNP, is statistically significant. Temporal precedence is not enough for our purposes, however, because the evidence that movements in consumer confidence precede movements in output can be interpreted in two ways. Either consumer sentiment causes GNP or it simply anticipates GNP.

We attempt to disentangle the two possibilities by estimating a series of vector autoregressions including GNP, consumer sentiment, and various other series that capture fundamentals or are good predictors of GNP. The working assumption is that if consumer sentiment can forecast GNP movements even after controlling for fundamentals and other publicly available predictors of output, some support is provided for the idea that consumer sentiment causes output fluctuations. In our baseline regressions, the control variable is an index of leading indicators, composed of fundamentals and purely predictive variables. To check for robustness we consider a number of other controls, a "textbook" set of fundamentals that includes government spending, money supply, and sensitive materials prices; components of the leading indicators; and a default risk variable that has been identified as an excellent predictor of output movements. For each set of vector autoregressions we test whether consumer sentiment Granger-causes GNP.

Our main finding is that even after controlling for economic fundamentals and other good predictors of GNP, changes in consumer sentiment have a statistically significant effect on output fluctuations. In other words, we find evidence of Granger causality running from consumer sentiment to GNP. We also attempt to assess the economic significance of consumer sentiment by decomposing the variance of GNP innovations. …

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