Forecasting Components of Consumption with Components of Consumer Sentiment

Abstract

We present new evidence that existing, but long-ignored, measures of consumer sentiment can reduce errors in forecasting total consumption expenditures and its components. The component questions of the aggregate Index of Consumer sentiment improve forecasts, not only of consumer expenditures on durables but also on non-durables and services. Empirical studies have historically focused on whether consumer sentiment improves one-quarterahead forecasts of consumer expenditures. In fact, we document that measures of consumer sentiment are especially predictive at the longer, four-quarter-ahead horizon. In addition, they typically contribute at least as much to one-quarter-ahead and four-quarter-ahead forecasts of consumption as do income and wealth variables. Out-ofsample forecasts for the 2000-2005 period further substantiate that measures of consumer sentiment can reduce consumption forecasting errors appreciably.