Smith Faculty Opinion Article - October 31, 2005

Personal Income Up $173.5 Billion in September:
Savings Negative Four Months in a Row
By Dr. Peter Morici, Professor of International Business

Today, the Commerce Department reported in September personal income increased $173.5 billion or 1.7 percent, disposable personal income increased $171.2 billion or 1.9 percent, and personal consumption expenditures increased $44.1 billion or 0.5 percent.

Most significantly, personal outlays exceeded disposable income by $32 billion or 0.4 percent. Personal savings have been negative for four straight months, households are critically stressed, and this raises a caution flag for the Fed.

Consumer spending, which accounts for 70 percent of GDP, has been the primary driver behind the economic recovery, and four straight months of negative savings indicate policymakers can no longer count on consumer spending to power growth. Business investment must pick up the slack.

Consumers have been able to increase spending more rapidly than their incomes by borrowing against the rapidly rising values of their homes and piling on credit card debt. However, the string appears to be running out.

Prices for existing homes are falling and credit card delinquencies are nearing 5 percent. With the exception of the July burst in auto sales, retail sales growth has been weak in recent months because consumers are now strapped.

Existing home sales account for 86 percent of all home sales, and last week the National Association of Realtors reported, from August to September, sales of existing homes were unchanged and the median sale price was down $8000, about 3.6 percent. Also in September, inventories of unsold homes were up for the sixth consecutive month, homes are sitting on the market longer, and the median sales price is at its lowest level since June.

All of this indicates the housing bubble may not have burst, yet, but the era of hyper appreciation is over. Households will no longer be able to use home equity loans to rapidly power ever greater levels of debt and spending.

The combination of falling housing values, consumer credit squeezed to near its limits and higher prices for fuels to commute to work and heat homes are squeezing families. Household liquidity is perilously thin and the Fed, by pushing up interest rates tomorrow, will add to this pressure. The new home, auto, mortgage and consumer credit industries are particularly vulnerable, and weakness in these sectors could derail the economic expansion.

The recent run up in energy prices has not created much inflation in the rest of the economy, and gasoline prices and petroleum and natural gas futures have been receding. We have seen the worst of the recent inflation, and the November 16 Department of Labor report will likely show consumer prices fell in October.

Although the Fed is almost certain to raise interest rates tomorrow and December 17, the economic performance that emerges over the next three months will likely indicate more caution after that.

For the economy to continue expanding at 3 or 3.5 percent a year or better, business investment will have to pick up the slack, and the Fed will have to engineer an interest rate environment that permits a cooling of the housing sector without overly stressing consumers heavily in debt and business plans for expansion. Nonresidential construction was the weak link in the business investment in the third quarter, and the Fed should seriously consider the implications of further credit tightening on that sector.

The prospects for weaker consumer and housing sectors and moderating inflation, coupled with the need to encourage business investment, indicate the Fed should pause in its march to push up interest rates to 4.5 percent. If it fails to heed these warning signs, the Fed risks throwing the economy into a tailspin.