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The Mystery of Consumer Confidence

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The preliminary estimate of the University of Michigan consumer confidence index unexpected dropped in March to the lowest level since last October. The headline index dropped from 77.5 to 68.2. But by far the worse drop was in the expectations of the future, which plunged from 58.3 to 71.6.

So what does plunging consumer confidence in the future mean for businesses, investors and consumers?

The truth is that no one really knows. Academics have tied themselves in knots trying to determine if consumer confidence accurately depicts current economic conditions or forecasts future economic performance.

Does consumer sentiment lead or lag the economy? Or is it just random noise?

According to one hypothesis, feeling that the future will be brighter may delay current spending—and drag down current economic growth.

“When consumers report that they expect to feel better off in the future, current expenditures stagnate as consumers delay purchases until a better time,” then-chair of the Minneapolis Fed Jean Kinsey wrote in a 1993 column.

Another theory says that this is exactly backward. Consumers don’t spend less when they expect to feel better off in the future—they spend more. Expectations of being wealthier in the future diminish the perceived need for future savings, permitting more current consumption. This is a version of what economists call the permanent income hypothesis.

It’s devilishly hard to figure out which theory is right, as numerous studies have shown. The evidence tends toward the theory that bright expectations leads to more spending, but there’s not really a consensus here.


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