Consumer behavior ; Consumption (Economics) ; Economic indicators

Adrian Throop

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 92-16, April 17, 1992
Causes and Effects
of Consumer Sentiment
The results indicate that sentiment helps to
explain spending on durables, but has no explan-
atory power for consumer purchases of nondur-
abies and services. Including the overall index of
consumer sentiment in the model reduces fore-
cast errors for durables over the 1976-1989 fore-
cast period by 8 to 20 percent, depending on the
To evaluate the usefulness ofconsumer sentiment,
or its components, for forecasting consumer ex-
penditures, I estimated a vector error correction
model of consumer sentiment, consumer expend-
itures on durables, expenditures on nondurables
and services, household disposable income, and
short-term interest rates for the period 1963-1975;
this model incorporates short-run relationships
among changes in these variables, as well as
long-run relationships among their levels. Since
the current change in any variable is estimated as
a function of past values of all the variables, this
model can be used to make ex ante forecasts
using only information prior to the forecast
period.
Shaded area denotes the 1981-82 recession; the peak
line indicates the beginning of the 1990-91 recession.
50
70
90
110
130
1983 1985 1987 1989 1991
Chart 1
Michigan Index of Consumer Sentiment
Peak
1981
Effects of consumer sentiment
The Michigan index ofconsumer sentiment,
shown in Chart 1, is based on responses to five
different questions, with equal weight given to
each. The responses to two ofthe questions con-
stitute the current conditions component of the
index (also shown inChart 1). One question asks
whether the household is better off or worse off
financially than a year ago, and the other asks
whether it is a good or bad time to buy a major
household item. The responses to the remaining
three questions make up the expected conditions
component of the index. These questions cover
expectations of the households' financial position
and the economic condition ofthe country in the
future.
Th is Weekly Letter reports on some recent re-
search on this issue (Throop 1992). This research
finds that consumer sentiment does have a sig-
nificantinfluence on household purchases of
durable goods. Normally, however, consumer
sentiment moves with current economic condi-
tions and bears a stable relationship to a few
economic variables. In this sense consumers
usually do behave mechanistically. But at times
of an unusual event, like the Gulf War, consumer
sentiment can move independently from current
economic conditions. At such times, surveys of
sentiment provide useful information about future
consumer expenditures on durables that is not
otherwise available.
George Katona (1975), who pioneered the devel-
opment and use ofthe Michigan index of con-
sumer sentiment, argued that while a purely
mechanistic view of consumer behavior some-
times may be correct, it is notnecessarily always
correct. Therefore, he believed that survey meas-
ures of consumer attitudes could contribute sig-
nificantly to both forecasts of consumer spending
on durables and a fuller understanding of con-
sumer behavior.FRBSF
forecast horizon. But including just the current
conditions component ofthe sentiment index
produces forecast errors that are 20 to 35 percent
lower. Thus, over the 1976-1989 forecast period,
the current conditions component ofthe Michi-
gan index of consumer sentiment is distinctly
superior to the overall index in forecasting con-
sumer expenditures on durables.
Consumer sentiment-usual circumstances
The model indicates that, in most circumstances,
changes in consumer sentiment-both the over-
all index and the current conditions component
-can be forecast simply from past changes in
interest rates. This result supports the notion that
consumer attitudes generally do respond mecha-
nistically to current economic conditions.
A more complex error correction model of con-
sumer sentiment revealed basically the same
result. The variables considered for the complex
model included household assets and liabilities,
changes in stock prices, the rate of inflation, the
unemployment rate or its rate of change, the real
price of oil or its rate of change, as well as inter-
est rates; but the only ones that appear closely
related to sentiment (either the overall index or
the current conditions component) in the long
run are the inflation rate and the civilian unem-
ployment rate. The higher the inflation rate or the
unemployment rate, the lower is the level of con-
sumer sentiment in the long run. In the complex
model, sentiment responds gradually to these
two variables. For example, only 25 percent of
the effect of a change in unemployment occurs
within the first quarter. In addition, in the com-
plex model short run changes in sentiment nor-
mally are both strongly and inversely related to
changes in interest rates and changes in the un-
employment rate, as well as being affected by
past changes in sentiment itself.
Over the 1976-1989 period the complex model
ofconsumer sentiment forecasts household pur-
chases of durables about as well as the simple
model does (even though realized values of
inflation and unemployment were used). More-
over, using the actual realized value of sentiment
(either the overall index or the current conditions
component) in the system does not reduce fore-
cast errors below those obtained by explaining
sentiment with economic variables. Thus, the
index of consumer sentiment, or its components,
normally does not contain any more relevant
information about consumer attitudes than is
already available in a small set of readily avail-
able economic variables.
Consumer sentiment-unusual circumstances
Although a model based purely on economic
variables normally does a good job of predict-
ing changes in consumer sentiment, during the
period of the Gulf War and thereafter it broke
down. This is shown for the overall index of sen-
timent in Chart 2. The complex statistical model
of sentiment was estimated through 1990.Q2.
Then the change in consumer sentiment was pre-
dicted over subsequent quarters on the basis of
actual future values of unemployment, inflation,
and interestrates. The actual index of sentiment
dropped precipitously through 1990.Q4 with
Iraq's invasion of Kuwait, then partially recovered
through 1991.Q3 following the allied victory, but
then dropped sharply again in 1991.Q4. In con-
trast, thepredicted value of sentiment rose con-
tinuously in this period, as the predicted effects
of falling interest rates and declining inflation
dominated over that of rising unemployment.
(Prediction errors using the simple model of sen-
timent explaining it just with interest rates are
even larger).
Chart 2
Consumer Sentiment
110
100
90
80
'----'------'_-'------'-_-'----'-_.L....--Jl ::
9001 9002 9003 9004 9101 9102 9103 9104
During the GulfWar when actual values of con-
sumer sentiment diverged from values predicted
by interest rates, inflation, and unemployment,
consumer expenditures on durables tended to
follow the actual path of sentiment. Also, in this
period the broader overall index of consumer
sentiment produced lower forecast errors than
the narrower current conditions component, con-
trary to the normal pattern. The likely explana-
tion is that the Gulf Warsignificantly alteredexpectations of future economic conditions rela-
tive to current economic conditions. Whereas
household perceptions of current and expected
future conditions normally tend to move relatively
closely together, in the second half of1990 the
Michigan index of expected conditions dropped
much more sharply than the index of current
conditions did.
The superiority of the overall index of cOilsumer
sentiment for measuring consumer attitudes dur-
ing theGulf War is most clearly seen in the pre-
dictions for consumer durables, using actual real-
ized values of all the explanatory variables, as
shown in Chart 3. The prediction of durables pur-
chases usingthe overall index follows the actual
decline in spending relatively closely. In contrast,
predictions using the current conditions compo-
nent of the index actually show a small increase
in spending, with the predicted effect of falling
interest rates on durables purchases tending to
offset the effect of the decline in the current con-
ditions component of sentiment. Finally, predic-
tions using only the three economic variables
show even larger increases in spending because
of an even greater dominance of interest rate
effects.
Chart 3
Predicted Expenditures on Consumer Durables
Billions of 1987 Dollars
530
505
480
455
430
~---'-_-'-----J'----'-_...L..----'_-L----'- 405
9001 9002 9003 9004 9101 9102 9103 9104
In the period following the Gulf War, survey val-
ues of consumer sentiment have continued to
diverge from the economic variables that usually
explain it. For example, in 1991.Q4 the sentiment
index once again dropped precipitously, but the
predicted value of sentiment rose. In this period,
consumer sentiment appears to have been driven
by economic variables, but not in the usual way.
Thus, for example, the percent of the people sur-
veyed by the University of Michigan who had
heard "bad news" jumped by as much as it had
during the Gulf War, even though inflation, un-
employment and interest rates changed relatively
little. How long this divergence between con-
sumei sentiment and the usual economic vaii-
abies lasts remains to be seen.
Conclusion
Consumer attitudes that influence expenditures
on durable goods normally are driven by the cur-
rent state of the economy, as reflected in unem-
ployment, inflation, and interest rates. As a result,
using either the current conditions component of
the sentiment index or the three economic vari-
ables that usually are closely related to it nor-
mally produces forecasts of consumer durables
that are superior to other forecast specifications.
The economic variables have an advantage, in
that they can be forecast as a part of the general
economic outlook.
The period during and following the GulfWar,
however, is an excellent example of a case in
which consumer attitudes have not mechanisti-
cally followed movements in current economic
variables. Other similar episodes that I have been
able to identify are Nixon wage and price con-
trols, the 1973-74 oil embargo, the 1987 stock
market crash, and Carter credit controls. Since
consumer attitudes affect consumer spending on
durable goods for several quarters into the future,
at such times the survey of consumer sentiment
can contribute significantly to the accuracy of
forecasts of durables purchases.
Adrian Throop
Research Officer
References
Katona, George. 1975. Psychological Economics.
New York: Elsevier Scientific Publishing Co.
Throop, Adrian W. 1992. "Consumer Sentiment: Its
Causes and Effects!' Federal Reserve Bank of San
Francisco Economic Review (forthcoming).
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
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Causes and effects of consumer sentiment

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Causes and effects of consumer sentiment

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