Until Consumers Start Splurging Hold the Hurrahs

Don't be fooled by economic growth figures released last Friday. True, the economy now appears to be expanding instead of shrinking. And that's all to the good.

But there is only one way the U.S. economy can return to healthy annual growth rates of 3% to 4%: American consumers will have to open their wallets even wider.

While exports and corporate spending can help the U.S. economy get back on track, they account for less than a third of U.S. economic activity. The rest in made up by consumer spending.

Indeed, the economy would still be mired in recession if it weren't for an uptick in consumer spending in the second quarter. The figures show that consumer spending rose by $23.5 billion, or 3.6%, in the period. That compares with a 1.5% decline in the first quarter and a 3.4% drop in last year's fourth quarter.

Consumers at the Wheel

"The only thing that's driving the economy right now is the consumer," says Wayne Ayers, chief economist at Bank of Boston.

Overall, the U.S. economy grew at an annual rate of 0.4% in the second quarter. That was considerably less than the 1% to 1.5% growth that had been expected.

Of course, the report is preliminary and could be revised in either direction. But on its face, the second-quarter performance looks so weak that some observers are worried that the economy may soon slip again, making for what is called a double-dip recession.

"I think we're out of the recession, but you can't prove it by this report," said Robert Dederick, chief economist at Northern Trust Co. "The double-dippers still live."

Exports on the Wane

Among the reasons that consumer spending is so important: Exports, an engine of economic stability during the recession, appear to be tailing off. The second-quarter report showed net exports fell by $18.6 billion from first-quarter levels. Thus, the $23.5 billion growth in consumer spending was largely offset by slack exports.

That's why economists are hoping for an even faster expansion of consumer spending in the current quarter. A typical postwar recovery, they point out, is led by auto sales, housing, and inventory build-ups. The same factors are likely to be building blocks to the current expansion.

Later on, if economic growth can be sustained, businesses can be expected to kick in with investments in plant and equipment as demand rises for products and services.

There is ample evidence that consumers should be in the mood to spend. Incomes are up, interest rates have eased, and inflation remains in check.

The easing of inflationary pressures translates into relatively more income in real terms. Put simply, dollars nowadays preserve more of their purchasing power because prices aren't rising rapidly. More purchasing power should mean more purchases, economists reason.

Impetus for Spending

Another positive sign: Goldman, Sachs & Co. has noted that real disposable income rose in May at an annual rate of more than 3%, while hourly wages are rising at a 7% clip. These income gains are spurring consumer spending, Goldman economists point out.

The fall in interest rates drives all economic activity, and none more so than housing starts. In the past year, mortgage rates have slipped to as low as 9.4%, the lowest rate in about four years.

"It's clearly helped the affordability of housing," says Alan Levenson, director of financial services at the WEFA Group.

Housing starts rose 5.2% to 1.04 million units in June, and permits for new homes rose 3.7%. This is the first time since November that housing starts are above the 1 million level, and the third sizable increase in a row. Both figures have now risen above their January lows.

Sellers Pounding Gavels

The housing recovery has been prodded in part by a sharp drop in the cost of homes. This shows up in the shelter component of the Consumer Price Index. In this year's first half, the component was falling at an annual rate of 4.5%.

With home prices low, home sales are taking off, helping not only the housing industry itself but ancillary industries, too, including appliances, furniture, and carpeting.

Housing costs are not the only component of the economy that's experiencing deflation. Energy costs have plunged this year as well. One result: Consumer prices rose by a mere 0.2% in June. What's more, for the first six months of this year, the annual consumer inflation rate has been a mere 2.7%.

With all these pieces in place, the economy should continue expanding. But keep an eye on consumer spending.

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