Evaluating Threshold Effects in Consumer Sentiment

Abstract

1. IntroductionThe 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. TheoryThis 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, (Formula Omitted. See article image.) where At is the real value of the individual's nonhuman wealth at the beginning of period t; β is the discount factor; YLt is real disposable labor income; and Et 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, λ (rule-of-thumbers), simply set consumption equal to income in each period, while a fraction (1 - λ) (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 λ 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. …