Consumers Spending More Than They Earn

I see a trend that I do not like. According to the Commerce Department, consumer spending–the major driver for economic growth–increased by 0.9 percent in December. Now, this may sound good on the surface, because we love to see people spend. It drives up the economy since consumer spending accounts for roughly two-thirds of GDP growth.

 And, based on what we saw last week with the Q4 GDP advancing at only 1.10 percent annualized, the slowest rate in three years, the strong growth in spending should be welcome. But, guess what? I’m not that excited and, in fact, somewhat concerned.

 Consider that incomes in December rose by 0.4 percent. This means consumers are spending more than they earn! You don’t have to be an economist to figure out this is surely not sustainable. When the spending rate outpaces income growth, you could be setting up for a crash. According to the Commerce Department, the savings’ rate for 2005 was at the lowest level it has been since the 30s, in the middle of the Great Depression.

 Now, I was not around then, but it doesn’t mean I should ignore this. In 2005, the savings rate was actually negative 0.5 percent. The reality is, consumers will need to either dip into their savings or borrow, and given that interest rates are higher, this could cause monthly financing costs to rise and thus decrease the discretionary income available for spending. This is not what we want to see as it could translate into reduced spending and lower GDP growth going forward. And, as I said in a recent column, there are some indications, albeit premature, that we may be on the crust of another recession. The yield curve is inverted, suggesting less optimism for economic growth going forward.

 Investors are hoping for a stop to rising interest rates as early as this year. Chairman Alan Greenspan is set to hand over the reigns to Ben Bernanke. The Federal Reserve is expected to raise the Fed Funds rate for the 14th consecutive time up to 4.50 percent at Tuesday’s FOMC meeting. The consensus is the Fed Funds rate could jump to 5 percent by the end of 2006. Rising interest rates trickle through the economy and impact consumer spending as financing costs rise and disposable income falls.

 So, watch if spending continues to outpace income growth. The decline in the savings rate is a concern as Americans are now among the biggest debtors in the world. And you know this cannot be good.