Kevin H. McIntyre,
Objectives:
The forecasting
power of consumer confidence indices for consumption spending is in sharp
contrast to the predictions of the permanent income hypothesis (PIH). This
paper attempts to reconcile these seemingly divergent propositions by
developing a “confidence augmented'' permanent income hypothesis (CAPIH).
Background:
Consumer
sentiment and its impact on the macroeconomy is a topic receiving increasing
attention from economists, policymakers, journalists, and financial analysts
alike. The basic argument suggests that consumer sentiment, measured using
indices created from household surveys, is an important determinant of not only
present, but also future household consumption expenditures. On a cursory
level, the evidence supporting this story is quite compelling. Indeed,
household consumption has tended to slow following a dip in consumer sentiment
and vice versa for decades (Abderrezak, 1997).
Evidence also
exists on a not-so-cursory level. A recent study by Bram and Ludvigson (1998)
shows that, depending on the confidence measure used, consumer confidence has
significant predictive power when forecasting household expenditures,
particularly consumer durables. Danthine et al. (1998) take this a step
further, linking consumer sentiment to agents' stochastic expectations
concerning long term labor productivity growth and hence permanent income.
Likewise, Matsusaka and Sbordone (1995) have shown that consumer sentiment
accounts for approximately 20% of the business cycle innovation in postwar U.S.
GDP. Accordingly, consumer sentiment affects not only the intensity of business
cycles, but also their duration.
As an explicit
measure of forward-looking behavior on the part of households, it is very
important to understand its relationship to the permanent income hypothesis
(henceforth PIH). In many ways, consumer sentiment fits naturally with the PIH.
It reflects the macroeconomic conditions such as the jobless rate, equity
prices and interest rates (among other things), and is thus a reflection of
permanent income. As a coincident indicator, it is highly correlated with the
present state of the economy and is good predictor of the future income and the
overall strength of the economy. Moreover, the predictive power of consumer
sentiment exceeds what is already found in other macroeconomic variables
(Acemoglu and Scott, 1994).
Along one very
important dimension, however, consumer sentiment is not consistent with
standard versions of the PIH. Under the PIH, consumer sentiment (and other
variables such as current income, inflation and unemployment rates, etc.)
should not have any predictive power for consumption. This, however, is not the
case empirically. Studies looking at sentiment often reject the PIH on the
grounds that consumer confidence is a good predictor of consumption and/or that
consumer confidence Granger causes consumption (Acemoglu and Scott; Matsusaka
and Sbordone, 1995).
This paper
attempts to reconcile the predictive power of consumer sentiment with the
permanent income hypothesis by developing a “confidence augmented” permanent
income model by introducing consumer confidence as a shift term to household
preferences.
Data:
The consumption
data used in this paper is N.I.P.A. consumption is of non-durable goods and
services. Income is measured using quarterly chain-weighted N.I.P.A. personal
income. Both consumption and income are
converted to per-capita terms. Four alternate measures of consumer confidence
are considered: the Conference Board's index of consumer confidence, the
Conference Board's index of consumer expectations, and their respective
A variety of
interest rates and asset returns are also considered. The primary interest
rates are either the yield on 3-month commercial
paper, the 3-month Treasury yield, or the 90-day CD rate. Stock returns are
measured using the Standard & Poor's 500 index.
Since it is reasonable to assume that households formulate consumption plans
taking into consideration the returns to all manner of assets they hold, I also
construct an “effective household interest rate,” a weighted average of the
above yields in addition to the return to real assets, i.e. housing, calculated
using the National Association of Realtors' median house price series. Nominal interest rates and asset returns are
converted to (ex-post) real rates using 4-quarter changes in the Consumer Price
Index. Finally, the sample period is 1978:Q1-1998:Q4, the former date
corresponding to first release of the Conference Board indices at monthly
frequencies.
Results:
Preliminary
evidence suggests that that so including consumer confidence does not
significantly alter the predictions of standard PIH models as far as the degree
of permanent income spending undertaken by households is concerned. In
contrast, including consumer confidence has significant implications for
intertemporal substitution: adding consumer confidence typically decreases
estimates of the intertemporal elasticity of substitution by up to a factor of
10. Further analysis shows that these results are largely invariant to the
measure of consumer confidence used, minor structural alterations to the
baseline model, and the choice of instrumental variables.