Unhappy Holidays

Consumer spending is the main engine of the U.S. economy, accounting for more than two-thirds of gross domestic product (GDP). But for the past two years, the engine has been sputtering. Much of its fuel, in the form of steady paychecks and easy credit, has evaporated. And many of its parts are aging: nearing retirement, the 78 million baby boomers are trying to rebuild the wealth lost in their homes and their 401(k)s. (Household net worth at midyear was down almost 19%, or $12.2 trillion, from its 2007 peak.) With the personal saving rate rising to an average of 4% in 2009, pundits speculate that a new frugality is taking root.

Indeed, consumer spending declined by 0.2% in 2008 and will probably fall by 0.6% in 2009, says Nigel Gault, chief U.S. economist at research firm IHS Global Insight. That's a stark contrast to the 3% to 4% annual growth that was typical for most of the past two decades. Even the recession year of 2001 experienced 2.7% spending growth, Gault points out.

When will the engine rev up again? There are some grounds for believing sooner rather than later. For example, consumer spending rose in August for the fourth straight month; the 1.4% increase was the biggest since 2001. Consumption rose 3.4% in the third quarter, according to the Commerce Department, while the economy grew at a stronger-than-expected 3.5% annual rate, signaling the end of the Great Recession.

But don't strike up the band just yet. Much of the third-quarter boost was due to federal stimuli, in particular the "cash for clunkers" car discount program, which ended in August. Consumer spending subsequently fell 0.5% in September. Wage growth remains flat, and many economists forecast GDP growth of less than 3% in 2010.

Then there's unemployment and its underappreciated cousin, underemployment, both of which are dismayingly high and likely to remain that way, say economists. David Wyss, chief economist of Standard & Poor's, predicts the unemployment rate, which reached 10.2% in October, will remain above 9% through 2012. "I don't see us getting back to normal 5% or 6% unemployment until 2013 or 2014 — if we're lucky," he says.

No Confidence
Consumers seem to sense that as well, and it continues to shake their confidence. The Conference Board's widely watched Consumer Confidence Index fell in October for the second straight month, to 47.7. Although that score is still far from the historic low of 25.3 recorded in February, in general a reading of 90 or above indicates a healthy economy, says Lynn Franco, director of The Conference Board Consumer Research Center. Moreover, on one question — consumers' income expectations six months out — "pessimists outnumbered optimists for the first time," says Franco.

Similarly, the Reuters/University of Michigan's Consumer Sentiment Index also dropped in October, to 70.6. The scale typically reads in the 80s or above during expansions, according to University of Michigan economist Richard Curtin, director of the consumer-sentiment surveys. Recent readings in the 70s signal that the worst is over, but the slide in October may indicate that consumers feel the recovery "may not have the legs they once hoped for," says Curtin.

If consumers are mildly optimistic about the general economy, they are practically in despair over their personal financial condition. Their personal-income expectations for the year ahead are "at the lowest level we've ever recorded, going back to 1946," Curtin says. "They've lost jobs, work hours, and bonuses. They don't see help on the horizon." He thinks it may take a decade or longer for unemployment to return to 5%.

As a result, consumer spending will lag, not lead, the economic recovery, predicts Curtin. "Consumers will use less debt and save more than they have in the past," he says. "Baby boomers are focusing on rebuilding their savings and investment funds for retirement."

Americans will spend more on cheaper private-label brands, keep their appliances and cars longer, and cut back on their driving, something people do anyway as they age, says Curtin. "This means that the rate of growth in consumer spending, which has been around 3.5% for the past 30 to 40 years, will drop to around 2.5% going forward, with negative repercussions on the rate of growth and employment," he predicts.

Higher taxes on the horizon may further reduce discretionary spending, notes Curtin. Two Bush-era tax cuts are scheduled to expire by the end of 2010, as well as the Obama payroll-tax cut enacted last year. And judging by legislation currently in Congress, some taxpayers could eventually face a new levy, to help pay for health-care reform.

Santa or Grinch?
A consumer-spending reality check is in the offing at this very moment as the all-important holiday shopping season reaches its peak. Some market researchers predict that holiday retail sales will modestly improve on last year's disastrous sales, which left retailers awash in inventory. Wyss of Standard & Poor's believes this year's sales are "going to be bad, but not as terrible as last year, if for no other reason than the stores are expecting it this time, so they're cutting back on inventory."

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