Research US: Upgrading our outlook for private consumption

• Retail sales showed an impressive increase in November and we have raised our forecast for real private consumption growth  in Q4 to 3.6% q/q AR. We expect the strong momentum to continue into 2011, as several factors  will  support spending.
• First,  on 6 December Republican and Democratic leaders in Congress reached agreement on the outline for a deal on extending the Bush-era tax cuts.
• We had expected an extension of the 2001/2003 tax cuts, but the package also include a payroll tax cut and extension of emergency unemployment benefits through 2011.
• The deal was approved by Congress last week and will lift personal disposable income in 2011 beyond what we had expected, and boost private consumption growth by 0.5pp compared with our previous 2011 forecast.
• Given the temporary nature of the tax cuts, there will be a payback in 2012. But by then the US economy will be in a better position to withstand the drag.
• Second, third-quarter flow-of-funds data showed a larger than expected increase in household net wealth. Hence, consumers’ balance sheets appear to be in better shape than we previously thought. 

Strong momentum in personal spending 
The extraordinarily strong November retail sales led us to upgrade our forecast for Q4  private consumption growth. Retailers have generally reported a strong start to the  holiday shopping season, which seems to have begun early this year. If early rebates have fast-forwarded some of the holiday  spending compared  with earlier years, this leaves some downside risks to December retail sales.


However, even with a conservative estimate of no growth in nominal personal spending in December, we revise up our forecast for Q4 personal spending growth to 3.6% q/q AR,from our previous estimate of 2.4%.
Looking forward, the outlook for private consumption in the first half of 2011 has also improved markedly lately (see below), and we expect the strong momentum in spending to carry through into 2011.

Highlights of the tax deal
On 6 December the Obama administration together with Democrats and Republicans in Congress agreed on a deal regarding tax policy for the next one to two years. Last week, Congress passed the tax bill with unexpectedly large bi-partisan support in both the Senate and the House.

The primary outcome of the deal was an extension of the Bush 2001/2003 tax cuts, which were set to expire on 1 January. This was widely expected and we had incorporated this outcome into our economic forecasts.
However, the deal also included some additional items, which we did not foresee. The most important are the following,First, a new payroll tax cut was agreed upon, to compensate for the expiring Making Work Pay (MWP) tax credit. Under current law, both employers and employees pay 6.2% in payroll withholding tax for Social Security on wages up to USD107,000. The tax compromise lowers the employee-paid portion to 4.2%, for one year. The cost of this oneyear tax holiday is USD120bn. Instead of the drag of USD60bn that we expected from the expiry of the MWP, the new tax cut provides a net boost to disposable incomes  of
USD60bn in the first half of 2011.

Second, the  Emergency Unemployment Compensation  program, which expired in November, will be extended through 2011. We had expected a shorter extension period of three months, and the one-year extension  gives an additional USD50bn boost to disposable income.

Finally,  the deal also allows for accelerated depreciation of business investment. In its current form, the compromise allows for total expensing of capital equipment spending in 2011 and 50% expensing for 2012. In total, this will reduce revenues by USD100bn over the coming two years.

Less fiscal tightening, larger deficits
Under the previous budget put forward by the President, the budget deficit was set to moderate to 8.7% of GDP in 2011and 5.7% in 2012. This included a significant tightening of the cyclically-adjusted budget deficit, amounting to a fiscal drag on GDP growth of around 1.5pp in both 2011 and 2012.

The tax compromise, would add around USD240bn to the budget deficit in 2011. As the payroll tax cut and extension of the emergency unemployment benefits are set to expire after one year, the deal will add a small USD30bn in 2012 on top of the deficit projected in the President’s budget. This implies that  the budget deficit is set to  increase to 10.3% of GDP in 2011 and decline to 5.9% of GDP in 2012.

This also implies less tightening of the cyclically-adjusted budget deficit in 2011. The fiscal drag on GDP growth next year will thus moderate to around 1pp. With a payback in 2012, the fiscal drag on GDP growth will rise to around 2.0-2.5pp. However, at that time we expect the US economy to be in much better shape to withstand the negative shock.

We see the labour market on a firm founding, with growth in payrolls of around 270,000 each month, and the release of pent-up investment and consumption to be ongoing.Improved outlook for consumer spending
The main direct impact  from the new tax deal  on GDP growth comes  via an upgraded outlook for consumer spending. As highlighted above, the tax bill dramatically changes the path for disposable income, and hence private consumption, in 2011.

According to our fundamental-based model for consumer spending, aggregate consumer spending usually reacts with a coefficient of one-third to changes in aggregate nominal disposable income growth.

The idea behind  this estimate is that one-third of US households are hand-to-mouth consumers, while the other two-thirds have full access to credit markets, and  therefore behave in accordance with the permanent income hypothesis and smooth their consumption to fit their lifetime income. Given the temporary nature of the tax cut, one might assume that spending should be less than one-third of the income boost. However, the fact that low-and middle-income households should benefit the most from the tax deal should work in the opposite direction.

The model assumes that all the extra income is spent straight away, but some consumption smoothing is likely. We expect the main positive impact to be in the first half of 2011, with a boost to private consumption growth of on average 0.7pp Q/Q AR. For 2011 in total, we expect the tax deal to boost private consumption growth by 0.5pp.

Consumer balance sheets better than expected 
There are other  factors than income  which affect consumer spending, such as wealth effects. With households smoothing their consumption over time in response to their asset wealth and total expected future income, fluctuations in net wealth to disposable income have a significant impact on households’ savings rate and consumption.

The Federal Reserve’s flow-of-funds statistics gives us updated information on the shape of households’ balance sheets and net wealth. Looking at the third-quarter flow-of-funds data at hand, we find that consumers’ balance sheets were in a better shape by the end of the quarter than we had expected. In particular, non-housing net worth turned out  to be higher than  anticipated, primarily because we underestimated the gain in equity-related net wealth.

The implication for consumer spending of this upside surprise in net wealth is positive. Even though wealth effects will be a negative contributor to consumer spending  in the coming quarters, this will be less than previously thought, the reason being that households need to do less precautionary saving than expected.

Upward revision to GDP growth,  risks remains on the upside
Summing it all up, we revise our forecasts for private consumption growth to 3.2% in 2011 and 2.6% in 2012, from 2.4% and 2.9% respectively. This implies an upgrade to overall GDP growth to 3.3% in 2011 and 3.2% for 2012, from 2.8% and 3.4% respectively.

This upgrade to growth in 2011 only takes into account the direct effect of the tax deal’s boost to incomes and private consumption. However, possible positive spill-over effects to the rest of the economy leave the risk to our forecasts skewed to the upside. First, there is massive pent-up demand in the economy, with both investment and consumption ratios way below their long-run averages. Strong growth in the first half of 2011 could give extra support to business sentiment, leading to a faster release of pent-up demand. Second, stronger growth and stretched productivity could also lead to a faster improvement in the labour market than we currently anticipate.
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