Smith Faculty Opinion Article March 1, 2006

Personal Income Up $75.2 Billion in January
Savings Negative Seven of the Last Eight Months
By Dr. Peter Morici, Professor of International Business


Today, the Commerce Department reported in January personal income increased $75.2 billion or 0.7 percent, disposable personal income increased $50.2 billion or 0.5 percent, and personal consumption expenditures increased $76.7 billion or 0.9 percent.

Most significantly, personal outlays exceeded disposable income by $63.3 billion or 0.7 percent. In December, personal outlays exceeded disposable income by $35.7 billion or 0.4 percent.

Personal savings have been negative seven of the last eight months, and consumers are critically stressed. This should raise a caution flag for the Fed but Chairman Bernanke seems intent on pushing up interest rates and driving core inflation below 2 percent.

Personal savings should improve in the months ahead. Consumers are overextended and a correction is inevitable. Pushing up interest rates further will hurry the process but raising rates too much could kill the economic expansion.

Outlook for Savings

Household savings should improve regardless of Fed policy.

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. In recent months, stressed by higher gasoline and heating costs, most consumers have had few short-term options but to pony up. Now the string appears to be running out.

Prices for existing homes have fallen since June, and credit card delinquencies are near 5 percent.

No longer able to take equity from their homes, consumers will make adjustments. New car purchases will tilt toward smaller vehicles, which are both less expensive and more fuel efficient. New homes will offer fewer amenities and perhaps less finished square footage too.

The combination of higher interest rates and declining housing prices will encourage consumers to rebuild their balance sheets and begin saving again. That will slow the economy, for sure.

Outlook for the Economy and Fed Policy

Consumer spending, which accounts for 70 percent of GDP, has been the primary driver behind the economic recovery the last four years. Eight straight months of negative household savings indicate policymakers can no longer count on consumers to power growth. With the federal government trimming discretionary spending and the trade deficit near record levels, investment must pick up the slack but that is unlikely.

Commercial construction is likely to pick up, especially in and around cities powered by knowledge-based industries, finance, and durable goods manufacturers, which other than Ford, GM and their suppliers, are recovering.

However, most new commercial construction will be limited to office and retail space, as durable goods manufacturers modernize equipment and squeeze more out of existing structures. Gains in commercial construction will be partly offset by a weaker housing sector. Investments in producer durables and technology will be decent but not spectacular.

Together, gains in construction, producer durables and technology spending will not be enough to keep the economy expanding at the pace established in 2004 and 2005.

Look for the economy to slow by the third quarter but the Fed wont see enough tangible evidence of this until May. That is why most forecasters are banking on two more increases in the Fed Funds rate.

The minutes of the January 31 Open Market Committee meeting revealed the regional Federal Reserve Banks forecasts for GDP, unemployment and core inflation. For GDP growth, the forecasts centered at 3.5 percent for 2006 and between 3 and 3.5 percent 2007; unemployment is expected to be between 4.5 and 5 percent in the fourth quarter of 2006 and between 4.75 and 5 percent the fourth quarter of 2007. Expectations for the core personal consumption expenditure (PCE) price index were in a range of 1-3/4 to 2-1/2 percent this year, centered at about 2 percent, and in a range of 1-3/4 to 2 percent in 2007.

Of the three variables, the PCE price index is the one the Fed worries about most and is best able to influence through its actions. Hence, the forecast for the PCE price index is a pretty good indicator of Feds inflation target, and targeting core inflation below 2 percent portends a tight monetary policy.

The Fed Chairmans effectiveness is significantly determined by his credibility with financial markets. If the economy slows but inflation is harnessed, Wall Street will crown Bernanke Caesar but if inflation gets out of control the same throng will make him the goat. All this compels conservative policies from a new Fed Chairman even when that is not good for the economy.

China and other Asian economies continue to soak up more and more oil and other resources. Although upward pressure on commodity prices have not filtered through to core consumer prices, the Fed is likely to err on the side of caution and hit the breaks too hard.

That would force a severe adjustment in the housing market and push up household savings a lot but it would kill the economic expansion. Downside risks are growing.

Peter Morici is an economist and professor at the Robert H. Smith School of Business, the University of Maryland, College Park, MD.
E-mail: pmorici@rhsmith.umd.edu