Uh Oh--Are Consumers Starting to Rein In Spending?

The mighty U.S. consumer may be starting to crack, just as the Federal Reserve signaled that
it was through with interest rate cuts barring a sharper economic downturn.

Shoppers in a toy aisle at a Target store.
Stephan Savoia
Shoppers in a toy aisle at a Target store.

Spending has held up remarkably well through months of nonstop news headlines about the free-falling housing market and record-high oil prices, propping up an economy that is limping through a housing recession.

But consumer confidence has eroded, and that is beginning to show up in quiet retail stores and disappointing sales.

Data released Thursday showed personal spending rose at a modest 0.3 percent annual rate in September, down from a revised 0.5 percent in August and slightly below expectations.

"Over the next few months, as the latest spike in gas prices bites, we expect to see weaker spending on goods and discretionary services, so fourth-quarter consumption will be
much slower than the 3 percent in the third quarter," said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

Retailers See Slowdown

Retailers are already seeing signs of that. Target , which has recorded strong sales growth in recent years, lowered its sales forecast in September and October.

Higher-end stores are starting to feel the pinch, too. Handbag maker Coach warned of weak traffic earlier this month, and forecast earnings below Wall Street expectations.

Some recession-sensitive businesses don't see things softening, though, like pawnshop operator CashAmerica.

"We're seeing very steady demand for our loan products and our retail business, and quite frankly, the empirical data within CashAmerica does not indicate any sort of downturn in the economy today," said CashAmerica president and CEO Daniel Feehan.

Back in early 2001, Federal Reserve Chairman Alan Greenspan worried about an abrupt "break" in consumer confidence, and the central bank began a rate-cutting frenzy that eventually took
the benchmark interest rate to 1 percent.

In testimony to Congress, he likened the erosion in confidence to "water backing up against a dam that is finally breached. The torrent carries with it most remnants of certainty and euphoria that built up in earlier periods."

Shortly after that testimony, the economy fell into recession, although it lasted all of eight months. The expansion that began in November 2001 appears to still be intact -- but confidence is once again showing deep cracks.

The current Fed, under Chairman Ben Bernanke, lowered interest rates by a quarter point Wednesday but sent a clear signal to Wall Street that unless economic conditions take a
turn for the worse, further cuts should not be expected.

Retrenchment Coming?

There has not been a particularly strong link between consumer confidence and spending in recent years, but a swift decline in confidence often prompts people to retrench, and
that is closely associated with recessions.

The break that Greenspan spoke of in February 2001 first appeared in late November 2000, said Richard Curtin, director of the Reuters/University of Michigan Surveys of Consumers. The
recession officially began four months later.

In November 2000, the University of Michigan's consumer sentiment index stood at 107.6, according to Curtin's database. One month later, it was at 98.4, a 9 percent drop. Last week,
the survey showed consumer sentiment at 80.9, the lowest in more than a year as concerns about the housing slump darkened the economic outlook.

While the index is much lower now than it was when Greenspan testified in 2001, the key seems to be how quickly the mood changes. Curtin said a "break" occurs when there is a
swift and widespread loss of confidence like the one in late 2000. While the October reading was poor, it was down only a modest 3 percent from the prior month.

When asked what might trigger such a break this time, he said, "Housing -- that's the No. 1 candidate. And we're perilously close to $100-a-barrel oil. These two negative trends could join and create an overall downturn."

Gasoline Prices to Rise

The downward trend is worrisome, however, and consumers are likely to be shouldering a heavier burden in the weeks to come as gasoline prices look set to rise.

To make matters worse, food company Kraft said earlier this week that dairy prices were up about 40 percent. Procter & Gamble , the largest U.S. consumer products maker, is raising prices on a host of everyday items including diapers, coffee and toilet paper.

For now, a relatively strong job market and wage growth have many people feeling OK about their financial position. A recent Reuters/Zogby survey found that more than half of
Americans polled rated their personal financial situation "good" or "excellent" -- yet only about a quarter gave U.S. economic policy such high marks.

White House economic adviser Edward Lazear blames that on a "disconnect" between what people see in their own checkbooks and the bad news they read in the newspapers.

"It's kind of a frustration because we can't quite understand the disconnect, but there definitely is one," he said at a recent round-table discussion.

If consumers act on those negative attitudes this holiday season, the Fed may have to rethink its hawkish position.

Reuters contributed to this report.