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Description
We present new evidence that existing, but long-ignored, measures of consumer sentiment can reduce errors in forecasting total consumption expenditures and its components. The component questions of the aggregate Index of Consumer Sentiment improve forecasts, not only of consumer expenditures on durables but also on non-durables and services. Empirical studies have historically focused on whether consumer sentiment improves one-quarter-ahead forecasts of consumer expenditures. In fact, we document that measures of consumer sentiment are especially predictive at the longer, four-quarter-ahead horizon. In addition, they typically contribute at least as much to one-quarter-ahead and four-quarter-ahead forecasts of consumption as do income and wealth variables. Out-of-sample forecasts for the 2000-2005 period further substantiate that measures of consumer sentiment can reduce consumption forecasting errors appreciably.
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Accuracy of forecasts of almost all macroeconomic variables, whether real or financial, typically depends importantly on how accurately households' consumption expenditures are forecasted. Decades of research have documented that income, wealth, and interest rate movements help account for changes in consumption. Decades ago, to complement these macroeconomic variables, the University of Michigan's Survey Research Center began asking, and still asks, households a series of questions about their views about their own and the national economy's recent, current, and expected future economic and financial conditions. These surveys intend to provide measures of consumers' willingness to spend. In that regard, consumer sentiment might serve as a useful complement to measures, such as income, wealth, and interest rates, that might signal consumers' ability to pay for consumption expenditures.
The best-known of the Michigan measures is its Index of Consumer Sentiment (ICS). The index is an aggregation of answers to five questions. (1) The ICS might improve consumption forecasts because it provides an instantly available measure (that is not subject to data revision) of households' evaluations of the current and upcoming conditions for themselves and the economy more broadly. Households' answers may reflect their evaluations of the current and upcoming impacts of recent shocks that have not yet left their imprint on macroeconomic variables. In addition, their answers might incorporate the effects on households' evaluations of the effects of changed expectations and uncertainties about future conditions. For example, simultaneous increases in the likelihood of and uncertainty about increased future tax burdens due to the changed prospects of certain presidential candidates might well reduce the numbers of households who answer that this is a good time to buy major household goods. Such a repercussion on households' evaluations often would not be captured by any of the macroeconomic variables that are typically embedded in consumption forecasting models.
Measures like the ICS may incorporate the extent to which households estimate the impacts of rare or even unique shocks--such as the first oil price shock and embargo in 1973--whose effects could not be directly or reliably estimated statistically from past data. Further, such measures might reflect households' evaluations of the impacts of changes in the structure of the economy. Thus, for example, appointment of a new Federal Reserve Chair who was widely anticipated to follow a distinctly different monetary policy might affect how households perceive future economic conditions. Households' changed expectations may well show up in their answers to surveys long before the changed structure of the economy can be distilled from macroeconomic data. Thus, surveys of households may rapidly provide data about households' evaluations of the impacts of events in circumstances where analysts often find it difficult to estimate impacts.
We focus on the improvements in forecasting consumption that measures of consumer sentiment might offer, especially once other macroeconomic variables are taken into account. In Section 1, we briefly survey prior studies of the marginal contributions of consumer sentiment to forecasting consumption. Section 2 shows the correlations between the aggregated ICS and its five component questions. Section 3 presents results from a baseline consumption forecasting specification that excludes any measures of consumer sentiment. Section 4 then presents new evidence that consumer sentiment does improve forecasts of consumer spending. In particular, we present evidence along several dimensions:
* We show that the individual component questions that comprise the ICS often much more significantly improve consumption forecasts than does the aggregated ICS that is constructed from those questions.
* We show that the individual component questions, and the aggregated ICS itself, provide much more reliable improvements in four-quarter-ahead forecasts than they do for one-quarter-ahead forecasts.
* We show that forecasts, not just of durables (or of vehicles in particular), but also of non-durables and services are improved by including individual component questions about consumer sentiment.
Sections 5 and 6 present evidence along two additional dimensions.
* We show that individual component questions tend to be at least as statistically reliable in improving forecasts of consumption and its components as are the usual income, wealth, and interest and inflation rate factors that form the baseline forecasting models of consumption growth. We present evidence, in turn, about which macroeconomic variables significantly improve consumption forecasts, once we also include various measures of consumer sentiment.
* We show how much out-of-sample forecasting errors of consumption growth, at both one-quarter and four-quarter horizons, for the 2000-2005 period are reduced by including various components of consumer sentiment.
Section 7 summarizes our findings and suggests promising areas for further research.
1. Prior Studies
Figure 1 plots quarterly averages of the ICS from 1960 through 2006. Not surprisingly, sharp declines in the ICS typically were accompanied by noticeable deteriorations in income, wealth, and other macroeconomic variables. Figure 2 plots the one-quarter and four-quarter-ahead growth rates of total consumption over the past ten years. (2) Of course, the one-quarter-ahead growth rates are much more volatile than those calculated year-over-year.
There has long been a robust simple correlation between consumer sentiment and consumer spending. The econometric evidence, however, is mixed on whether, once other measured macroeconomic factors are allowed for, consumer sentiment affects consumer expenditure. A number of studies argue that consumer sentiment is significant in "old-fashioned-structural" equations for consumption expenditures. Juster and Wachtel (1972a, b), for example, long ago showed that "anticipatory variables" (including the ICS) usually add to the explanatory power of automobile and consumer durables demand equations. They also report that consumer sentiment is of considerable importance in forecasting automobile expenditures. Kelly (1990) reports that in the DRI model, consumer sentiment directly affects consumer spending, imports, business inventories, and industrial production. Changes in consumer sentiment have particularly noticeable effects on housing starts and the growth of auto sales.
In addition, Carroll, Fuhrer, and Wilcox (1994) find lagged ICS significant in "new-fashioned-structural" equations for consumption growth. They show consumer sentiment helps predict future changes in consumption, regardless of whether other variables, such as income growth, are included. They favor the interpretation... |
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