Tuesday, May 01, 2007

Personal Income and Spending

Yesterday the BEA gave us some new data about personal income and spending for March of 2007. You can find the news release here, but what I want to focus on today are the reasons why I am worried about the prospects for consumption growth in the coming months.

Actually, my concerns can be summarized in a picture. The following graph shows the annual growth in consumption and in labor compensation, with both series adjusted for inflation using the PCE deflator. The red line then shows the savings rate for US households.

As I've discussed before, income growth for households that get their income through their labor has been sluggish during this economic recovery. Profits have been strong, and the income of people who get a lot of their income from their ownership of US corporations has done well... but labor income has generally struggled along at 2-3% real growth for the past several years.

Consumption growth, on the other hand, has been considerably and consistently stronger. How is that possible? There are three ways. First, households have spent an ever-growing portion of their income... so much so that by 2005 the savings rate actually turned consistently negative for the very first time. Second, some American households have enjoyed strong income growth from non-labor sources. I'm referring mostly to those profits that I mentioned above. Third, many households have used mortgage equity withdrawals to finance their consumption.

These various sources of money for households to spend have propped up consumption growth at a solid level despite relatively weak growth in labor income. But there are good reasons to guess that all three of these supports for consumption are running out.

The end of the housing boom and concomitant MEW phenomenon has been well documented by others (yes, I'm talking about Calculated Risk), so that source of money is drying up. Corporate profits have grown amazingly well in recent years, but probably can't continue that pace for much longer.

That leaves changes in the savings rate. But if anything, it is starting to seem like we are entering a phase where households will be more interested in moving their savings rate back toward zero, rather than allow it to become more negative. However, to bring the savings rate back toward zero (not to mention positive) households will have to allow several period elapse with rates of consumption growth below the rate of income growth.

Put it all together, and it seems quite likely to me that we're in for a period of slower consumption growth. And given the importance of consumption in the US's economic growth right now, that does not spell good news for the economy as a whole.

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