Evaluating threshold effects in consumer sentiment.

• Author: Desroches, Brigitte

1. Introduction

   The Consumer Sentiment Index published by the University of Michigan (hereafter the UM index) is one of the two most commonly monitored measures of consumer sentiment in the United States (the other one being the Consumer Confidence Index issued by the Conference Board). Sentiment indexes, which are constructed from answers to survey questions, are popular with the media; newspaper articles and commentaries abound following their release. The analysis often confers a primary role to consumer sentiment in determining economic fluctuations. The view among economists, however, is more equivocal. As early as 1965, Adams and Green found that the information contained in the UM index encompasses the information included in standard government statistics on employment and financial conditions. Many economists think that consumer sentiment is endogenous and is a reflection of current macroeconomic conditions. Other economists, in line with Keynes' notion of animals spirits, argue that psychological factors, which are not captured by economic variables, can influence consumers' decisions. Thus, the willingness to consume may be an important factor affecting consumption.

   Few studies have found that sentiment indexes have significant explanatory power once fundamental economic factors are taken into account. Garner (1991) and Throop (1992), however, performed event studies and suggested that these indexes could be helpful during major economic or political events, as they then tend to diverge from a path consistent with other macroeconomic variables. Drawing on this literature, our study provides a new evaluation of consumer sentiment as a predictor of aggregate consumer spending.

   Periods of high economic or political uncertainty are usually associated with increased volatility of consumer sentiment, suggesting that large swings in sentiment could influence consumption. We provide a formal assessment of this possibility by estimating a consumption function in which only large variations of sentiment affect spending. We find that consumer sentiment is a statistically important determinant of consumption in periods of high uncertainty, even after controlling for other determinants of consumption.

   This article is organized as follows. Section 2 describes two views of consumer behavior. Section 3 reviews the relevant empirical literature. Section 4 introduces our econometric model, data, and estimation methods. Section 5 summarizes the estimation and forecasting results. Section 6 evaluates the predictive power of the UM index within the Campbell--Mankiw (Campbell and Mankiw 1990) framework. Section 7 concludes.

2. Theory

   This section briefly reviews the theory of consumer behavior and discusses possible links to consumer sentiment. The permanent income hypothesis (PIH) states that consumers' expenditures depend on their permanent income. Permanent income is defined as the present value of wealth,

   [Y.sub.Pt] = [A.sub.t] + [E.sub.t] [[infinity].summation over (i=o)] [beta.sup.i][Y.sub.Lt+i],

   where [A.sub.t] is the real value of the individual's nonhuman wealth at the beginning of period t; [beta] is the discount factor; [Y.sub.Lt] is real disposable labor income; and [E.sub.t] is the expectation operator conditional on information available to the individual at time t.

   Campbell and Mankiw (1990) test Hall's (1978) random walk hypothesis by separating consumers into two groups. A proportion of households, [lambda] (rule-of-thumbers), simply set consumption equal to income in each period, while a fraction (1--[lambda]) (life-cyclers) behave according to the PIH. In this framework, the only reason any lagged variable could have predictive power for current consumption growth is because that variable has predictive power for current income growth, and the [lambda]. consumers do not spend that income until it arrives. In that context, the usefulness of consumer sentiment should come from the fact that it captures information about expected future income. On the other hand, if consumer sentiment has explanatory power beyond that of predicting future income, then the Campbell-Mankiw framework would be rejected.

   A more psychological approach to consumption was pioneered by Katona (1975). In Katona's view, consumer expenditures are a function of both capacity and willingness to consume. According to the psychological theory, willingness (as captured by sentiment) to consume cannot be explained only by the reaction of consumers to economic variables. In this view, a drop in sentiment can, by itself, cause a decline in consumption in a way not foreseen by economic variables (i.e., without a decrease in income). Willingness to consume is negatively related to uncertainty (Acemoglu and Scott 1994). Even if consumers' financial position is actually unchanged, higher perceived uncertainty can lead to a decline in consumption, as increased uncertainty reduces marginal propensity to consume. In this context, the usefulness of sentiment comes from its ability to convey consumers' assessment of uncertainty. It can therefore be linked to precautionary saving models of consumption (Carroll 1992).

3. Review of Empirical Literature

   In this section, we summarize the empirical literature on the use of consumer sentiment indexes in a consumption function. We begin by briefly reviewing the explanatory variables typically found in these analyses.

   Explanatory Variables

   To evaluate the informational content unique to sentiment indexes, they must be purged of information that could come from their determinants. The inclusion of such variables in a consumption equation will ensure that the addition of sentiment indexes provides further explanatory power only to the extent that the indexes capture information relative to expected income, uncertainty, or at least information not found in standard macroeconomic data. These control variables are disposable income (a proxy for expected income), unemployment rate and inflation (proxies for uncertainty), (1) interest rates and stock prices (proxies for information from financial markets), (2) and net worth (a proxy for nonhuman wealth).

   The information contained in these explanatory variables can be evaluated by calculating the [R.sup.2] of the following regression equation:

   (1) U[M.sub.t] = [mu] + [beta][X.sub.t] + [v.sub.t],

   where UM stands for the University of Michigan Consumer Sentiment index and X is a vector containing the aforementioned variables. Estimating Equation 1, we find that about 72% of the variation in the index can be explained by the components of X.

   Thus, some of the variations in consumer sentiment cannot be explained by standard macrovariables, suggesting that [v.sub.t] could be used in a consumption equation to assess the incremental explanatory power of sentiment. In our empirical model, we use sentiment with the addition of the components of X, as this procedure involves only one estimation step.

   Forecasting Value

   The findings in the empirical literature on consumer sentiment indexes can be divided into three groups. First, the indexes are of negligible value. Fuhrer (1993) finds that the UM index is a statistically significant predictor of consumer spending, but that its explanatory power fades in the presence of income in the equation. Hymans (1970), Mishkin (1978), Burch and Gordon (1984), and Garner (1991) also find that sentiment indexes lose their significance with the addition of controls.

   The second group includes studies finding that sentiment indexes have an incremental explanatory value. Carroll, Fuhrer, and Wilcox (1994)...