Monday, October 30, 2006

Musings on income growth

It sure feels like there are two camps about where the economy is going, and incoming data is only causing parties in both camps to harden their positions.

Today we have personal income and personal spending. Personal income growth for September came in a fairly strong +0.5%. Incomes are up a healthy 6.8% YoY (3.9% in real terms), which is well above the 20-year average of 5.5% (or 2.8% in real terms). Those thinking the economy is still strong and inflation is a concern can point to strong income growth.

Consumer spending is a different story. It grew a meager 0.1% for September. Consumer spending has risen 5.5% over the last 12-months, below the 20-year average of 6%. Real consumer spending is up 3.4% YoY, which is right on the long-term average.

I look at this data and see at worst a modest slowdown. Consumers spend about a year paying down some of the debt they incurred during the housing boom, then its back to spending as usual. The savings rate right now is -0.2%. If we assume consumers "want" to have a savings rate around 1%, income is growing at 7% (nominal) per year, spending can grow at a 5.8% (nominal) rate over the next year, then resume growing at 7% thereafter. That'd be around 3% spending growth in real terms, only about 0.4% weaker than the long-term average. If we take the rule of thumb that 70% of the economy is consumer driven, that's about a 0.3% ding against real GDP.

I don't see the Fed cutting if this is how it plays out as I just described. But that description is a little overly simplistic. We know there are some housing-related challenges looming. The Calculated Risk blog argues that the impact from weak housing is yet to be felt, both because construction job losses will accelerate and because mortgage equity withdrawal (MEW) with continue to decline.

How far MEW falls depends entirely on how severe the housing correction turns out to be. To me, if income continues to climb, the glut of home inventories will work it self out without needing deep declines in home prices. So MEW settles in around +$200 billion, which is where it was in the late 1990's. That's a decline of around $300 billion from where it was in the 2nd quarter, or 2.2% of GDP. I'm using Federal Reserve figures here: estimates of MEW vary greatly. Anyway, the Fed thinks about half of MEW feeds into GDP, so a decline in MEW probably weighs on GDP to the tune of 1.1%.

Would the Fed cut in response to a 1.1% decline in GDP? Probably, but if they estimated that the impact was a one-off, its not going to be an aggressive campaign. In other words, if the impact of MEW is -1.1% in 2007 but its clear the housing market has stabilized, income and spending are growing, I can't see the Fed cutting more than 50bps or so. To do more would risk inflation at a time when the economy is on an upswing.