The power of sentiment: Irrational beliefs of households and consumer loan dynamics

Abstract

We examine whether household sentiment can explain fluctuations in newly issued consumer loans. We construct a novel measure of household sentiment using detailed data from the harmonized consumer surveys conducted in European countries. We differentiate between rational sentiment, which mimics dynamics in macroeconomic fundamentals, and irrational sentiment, which proxies households’ optimism/pessimism on top of their rationally sourced beliefs. We show that shocks to the sentiment of households do have a measurable impact on growth of consumer loans. Specifically, we assert a significantly positive role of irrational sentiment on top of the economic fundamentals identified in the literature. Moreover, a closer examination reveals that the studied relationship is not symmetric over the business cycle — the effect of irrational sentiment is present only in periods in which a country’s output is well above its potential.