An Econometric Analysis of Consumer Sentiment and ... - NABE

An Econometric Analysis ofConsumer Sentiment andConfidence Indexes: PullingTrigger EffectsbyChris G. Christopher, Jr.July 1, 2011

An Econometric Analysis of Consumer Sentiment and Confidence Indexes:Pulling Trigger EffectsWe offer an overview of IHS Global Insight's econometric research on the determinants of consumer mood, usingtraditional explanatory variables such as gasoline prices, initial unemployment insurance claims, the unemploymentrate, and equity prices.In this special report, we offer an overview of IHS Global Insight’s research on the determinants of consumer attitudesusing traditional explanatory variables as well as psychological “trigger points” from the field of behavioral economics.In addition, we give a brief overview of behavioral economics. In subsequent articles, we will focus on thedeterminants of inflationary expectations and Bloomberg's weekly comfort index. Since this report is somewhattechnical and lengthy, we have also provided a relatively brief summary as a perspective article: Consumer Feelingsand Economic Reality, by Chris G. Christopher, Jr. (June 6, 2011).The Conference Board's consumer confidence and Reuters/University of Michigan’s consumer sentiment indices aretwo widely used measures of consumer attitudes and the factors that drive consumer spending. Personalconsumption represents approximately 70% of GDP and is a key component in our understanding of business cycles.IHS Global Insight’s large-scale quarterly U.S. econometric model forecasts and utilizes the Reuters/University ofMichigan's consumer sentiment headline and short-term inflation expectations indices. Sentiment is a driver forvarious inflation-adjusted consumer expenditure components. Inflation expectations affect interest rates, wage rates,and the rental cost of capital.First, we give a brief overview of the current state of behavioral economics in the overall context of “mainstream"economics. We then discuss the econometric models and data used, and outline our key findings. Finally, we offersome brief conclusions.The Homo Economicus Assumption and Behavioral EconomicsMost modern mainstream economics analysis assumes that individuals behave as Homo Economicus (EconomicHuman). In this analytical framework, individuals behave under a narrowly defined “rationality” with purely selfinterestedmotives, where economic agents are strict “utility” maximizers with not much consideration of social,cognitive, or emotional factors in the understanding of human actions. Mainstream economists (Neo- or New-Keynesian, Classical, Neo-Classical, etc.) assume Homo economicus as the starting point in developing theirrespective theories and, in most cases, do not consider it necessary to challenge or empirically test this vital andhighly restrictive assumption. Most other social sciences, however, such as anthropology, sociology, psychology,behavioral sciences, and nonmainstream economics, have rejected the concept of Homo economicus. There isconsiderable agreement that human actions are rational in many circumstances, but not to the extreme of Homoeconomicus—there has to be room for emotions, and spontaneous innate urges.The two major nonmainstream economic schools of thought—Keynesian/Post-Keynesian (M. Keynes, HymanMinsky) and Austrian (Karl Menger, Ludwig Von Misses, F. A. Hayek)—diverge on economic policy prescriptions, butagree that the assumption of Homo economicus is erroneous and lead to ineffective policy prescriptions. According toJohn Maynard Keynes' The General Theory of Employment, Interest and Money, "[...] of our decisions to dosomething positive, and the full consequences of which will be drawn out over many days to come, can only be takenas a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome ofweighted average of quantitative benefits multiplied by quantitative probabilities."[2].1 IHS Global Insight Published 7/1/11

The relatively new and developing fields of behavioral and experimental economics, evolutionary psychology, andneural sciences offer valuable insights and scientific evidence as to the behavior of individuals in the context ofhuman action. While these fields of research often disagree with each other on the reasoning and conclusionspertaining to human behavior, they find common ground in their rejection of Homo economicus and provideconfirmation to the analytical framework developed by the classical “liberal” tradition of the 19th century andexemplified in the works of Hayek. The field of behavioral and experimental economics has made significant inroadsinto the mainstream economics establishment, while several pioneers in the field have been awarded the NobelMemorial Prize in Economic Sciences. Behavioral economists attempt to empirically define the limits of humanrationality as being bounded and not without limits.The Reuters/University of Michigan consumer sentiment index was designed after World War II at the University ofMichigan by the eminent psychologist George Katona, whose pioneering efforts focused on integrating economicpsychology with macroeconomic theory, modeling, and forecasting. Katona maintained that there was a sharpdifference between income (the ability to buy) and the willingness to buy (consumer psychology). His argument wasthat if people feel better off, they will spend more, while if they feel worse off, they will spend less.Econometric Model, Data, Priors, and MethodologyThis section is a non-technical overview of the statistical results and terminology. We then describe in more detailsome key econometric results, and finally offer some broad insights and conclusions.We estimate monthly consumer sentiment and consumer confidence regressions in a structured time seriesframework. Due to data limitations, the time span is January 1994 through December 2010. The Conference Boardhas employed a different indexing methodology since 2011 that makes yearly comparisons difficult to interpret. Thus,we leave the sample endpoint for consumer sentiment at December 2010 as well, to allow for comparisons with theconsumer confidence regression results.To develop a practical model of the determinants of consumer attitudes, we expand on the traditionally usedexplanatory variables—such as inflation-adjusted gasoline prices, unemployment, stock market performance, pastconsumer optimism, seasonal controls, and recession controls—with variables from behavioral psychologyeconomics.The formal econometric representations of the consumer sentiment and consumer confidence regression equationsareCS(t) = Intercept + Seasonal Dummies+ b11*Relative Price of Gasoline(t)+ b12*SP500 Composite Growth Rate(t)+ b13*Initial Claims per Capita(t) + b14*Unemployment Rate(t)+ c11*Gasoline Price Trigger(t) + c12*DJIA Value Trigger(t)+ d11*2001 Recession(t) + d12*Great Recession(t)2 IHS Global Insight Published 7/1/11

+ b15*CS(t-1)+ e1(t)CC(t) = Intercept + Seasonal Dummies+ b21*Relative Price of Gasoline(t)+ b22*SP500 Composite Growth Rate(t)+ b23*Initial Claims per Capita(t) + b24*Unemployment Rate(t)+ c21*Gasoline Price Trigger(t) + c22*DJIA Value Trigger(t)+ d21*2001 Recession(t) + d22*Great Recession(t)+ b25*CC(t-1)+ e2(t) .Data Description and PriorsItalics denote natural log transformations. The variables CS(t), CS(t-1), CC(t), CC(t-1), Relative Price of Gasoline(t),SP500 Composite Growth Rate(t), Initial Claims per Capita(t), and Unemployment Rate(t) are in natural logs and theirrespective regression coefficients (b11, b12, b13, b14 b15, b21, b22,b23, b24, b25) are interpreted as elasticities.The non-italicized variables Gasoline Price Trigger(t), DJIA Value Trigger(t), 2001 Recession(t), Great Recession(t),and Intercept are dummy variables (binary).Consumers live, feel, and act in a mostly not-seasonally adjusted world, and therefore we control for seasonalitythrough the use of seasonal dummies. Consumers do react to seasonally and not-seasonally adjusted concepts. Forexample, when buying groceries or gasoline they react to the not-seasonally adjusted prices most of the time.However, consumers do react to seasonally adjusted economic variables that get wide media coverage such as GDPor the unemployment rate.Dependent Variables, and Lagged Dependent Variables: "CS(t)" denotes the monthly Reuters/University ofMichigan's consumer sentiment index at time period "t," and "CC(t)" denotes the Conference Board's consumerconfidence index. "CS(t-1)" and "CC(t-1)" are lagged consumer sentiment and consumer confidence, respectively(previous month's value). For the sake of brevity, we drop the monthly time index for the remainder of this article. Ourexpectations on the lagged dependent variable coefficients are that they should be positive and below one.Explanatory Variables: "Relative Price of Gasoline" denotes the not-seasonally adjusted (NSA) price of gasolinedivided by the Consumer Price Index (NSA). The "SP500 Composite Growth Rate" denotes the average monthlyStandard & Poor's 500 Composite Index divided by the previous month's average Standard & Poor's 500 CompositeIndex. "Initial Claims per Capita" denotes the average monthly seasonally adjusted initial unemployment claimsdivided by the seasonally adjusted U.S. civilian population 16 years of age and older. "Unemployment Rate" denotesthe seasonally adjusted unemployment rate from the Household Survey.3 IHS Global Insight Published 7/1/11

Our expectations on the coefficients of Relative Price of Gasoline, Initial Claims per Capita, and Unemployment Rateare negative. Initial claims per capita has a traditional economic interpretation, while the relative gasoline prices andunemployment rate do not, since these concepts are widely monitored and people tend to react to these indicatorsmore readily. Our expectation on the coefficient of the SP500 Composite Growth Rate is positive. The Initial Claimsper Capita is seasonally adjusted to take into account the multitude of seasonal patterns expected by consumers.The Unemployment Rate is seasonally adjusted, since it is reported in the media as such. The Relative Price ofGasoline is not seasonally adjusted, since consumers react to the price they observe at the pump. The SP500Composite Growth Rate is constructed from not-seasonally adjusted data.Behavioral Trigger Points: The Gasoline Price Trigger and DJIA Value Trigger are two behavioral economic"dummy" or qualitative variables that attempt to capture round-value trigger points. The Gasoline Price Triggerdummy variable is constructed from the average monthly not-seasonally adjusted gasoline prices. If the monthlyaverage gasoline price is increasing and if it surpasses a round dollar figure in a given month—$3.00/gallon,$4.00/gallon—then the Gasoline Price Trigger dummy is set to one for that month and the previous month, and set tozero for all other months. The average gasoline price movement is weighted by population. In a period of increasinggasoline prices, certain parts of the country will experience the round dollar impacts sooner than others. Thegeographic dispersion of gasoline prices is mostly due to state-specific sales and excise taxes, as well as differencesin the particular reformulation or blend and distance from suppliers.The DJIA Value Trigger dummy variable is constructed from the monthly average Dow Jones Industrial Average(DJIA) index. If the monthly average DJIA is increasing and surpasses a round 1,000 value mark—11,000 or12,000—then the DJIA Value Trigger dummy variable is set to one for that month.Our expectation on the Gasoline Price Trigger coefficient is negative and on the DJIA Value Trigger coefficient it ispositive. We performed an extensive literature search on the qualitative and econometric analysis of consumersentiment and confidence. To the best of our knowledge, this is the first econometric study that attempts to measurethe effect of these two types of round-value figures on consumer sentiment and confidence. This round-value impactis well known to retailers, where consumer demand is sensitive to pricing one penny below a round dollar figure—$99.99 or $9.99.Recessions: The 2001 Recession and Great Recession dummy variables are placed in each regression equation tocapture the movement in consumer sentiment and confidence excluding the effects of the seasonal factors and theother right-hand-side variables during a recession. The 2001 recession was officially dated from March 2001 throughNovember 2001. The Great Recession lasted from December 2007 through June 2009. Our expectation on these tworecession dummy variable coefficients is that the Great Recession coefficient should decrease consumer sentimentand confidence more than the 2001 Recession coefficient (d12 < d11 and d22 < d21), since the 2001 recession isgenerally regarded as a mild business-led recession and the Great Recession marked the end or break of the "GreatModeration" and was consumer-led. For a brief discussion of Great Moderation and consumer mood please refer to[1].Technical AnalysisEach regression equation was estimated separately with IHS EViews software. The results are presented in thetables below. Lag lengths were tested on the appropriate regressors while several diagnostic tests were computed.Each regression exhibits anadjusted R-squared of 0.94 for consumer sentiment and 0.96 for consumer confidence.The Relative Price of Gasoline, SP500 Composite Growth Rate, Initial Claims per Capita, and lagged dependent4 IHS Global Insight Published 7/1/11

variable estimated coefficients were the expected sign and statistically significant at the 5% level. The UnemploymentRate coefficient was not statistically significant in consumer sentiment regression, but was negative withapproximately 5% level of significance in the consumer confidence regression.The Gasoline Price Trigger and DJIA Value Trigger coefficients were the expected sign and statistically significant atthe 20–25% level range for the consumer sentiment regression and in the 5–14% level range for the consumerconfidence regression. The absolute values of the t-ratios on the triggers were above one, thus contributing to thesignificance of the regression (F-statistic).The 2001 recession dummy coefficient was greater than the Great Recession dummy coefficient in each of theregressions. However, the absolute value of the t-ratio on the 2001 recession coefficient was below one in theconsumer sentiment regression.5 IHS Global Insight Published 7/1/11

Consumer Sentiment RegressionSample January 1994–December 2010Variable Coefficient Std. Error t-ratio Prob.Intercept 0.360 0.360 0.999 0.319Relative Price of Gasoline -0.151 0.024 -6.359 0.000SP500 Composite Growth Rate 0.319 0.079 4.030 0.000Initial Claim per Capita -0.205 0.049 -4.190 0.000Unemployment Rate -0.001 0.029 -0.024 0.981Gasoline Price Trigger -0.014 0.011 -1.255 0.211DJIA Value Trigger 0.008 0.007 1.141 0.2552001 Recession 0.013 0.017 0.795 0.428Great Recession -0.032 0.016 -1.965 0.051Previous Month's Consumer Sentiment 0.626 0.054 11.563 0.000Jan. Seasonal 0.016 0.013 1.176 0.241Feb. Seasonal -0.021 0.014 -1.571 0.118Mar. Seasonal -0.006 0.014 -0.424 0.672Apr. Seasonal 0.000 0.014 -0.006 0.996May Seasonal 0.008 0.014 0.595 0.552Jun. Seasonal 0.020 0.014 1.450 0.149Jul. Seasonal 0.011 0.014 0.765 0.446Aug. Seasonal -0.002 0.014 -0.173 0.863Sep. Seasonal 0.001 0.014 0.045 0.964Oct. Seasonal -0.017 0.014 -1.215 0.226Nov. Seasonal -0.007 0.013 -0.545 0.587R-squared 0.945Adjusted R-squared 0.939Durbin-Watson stat 1.975S.E. of regression 0.039F-statistic 157.508Prob(F-statistic) 0.0006 IHS Global Insight Published 7/1/11

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Consumer Confidence RegressionSample 1994.01 - 2010.12Variable Coefficient Std. Error t-ratio Prob.Intercept -0.338 0.576 -0.587 0.558Relative Price of Gasoline -0.140 0.034 -4.156 0.000SP500 Composite Growth Rate 0.699 0.133 5.263 0.000Initial Claim per Capita -0.293 0.081 -3.619 0.000Unemployment Rate -0.118 0.061 -1.920 0.057Gasoline Price Trigger -0.038 0.019 -1.992 0.048DJIA Value Trigger 0.025 0.016 1.510 0.1332001 Recession 0.030 0.029 1.039 0.300Great Recession -0.064 0.028 -2.316 0.022Previous Month's Consumer Sentiment 0.706 0.052 13.603 0.000Jan. Seasonal -0.018 0.023 -0.805 0.422Feb. Seasonal -0.064 0.023 -2.792 0.006Mar. Seasonal -0.007 0.023 -0.325 0.746Apr. Seasonal 0.031 0.023 1.338 0.183May Seasonal 0.031 0.023 1.314 0.191Jun. Seasonal 0.000 0.024 -0.018 0.985Jul. Seasonal 0.005 0.023 0.210 0.834Aug. Seasonal 0.010 0.023 0.424 0.672Sep. Seasonal -0.022 0.023 -0.940 0.349Oct. Seasonal -0.064 0.023 -2.770 0.006Nov. Seasonal 0.009 0.023 0.385 0.701R-squared 0.965Adjusted R-squared 0.961Durbin-Watson stat 1.790S.E. of regression 0.066F-statistic 253.707Prob(F-statistic) 0.0008 IHS Global Insight Published 7/1/11

Key PerspectivesThe regression results point to similar determinants of consumer sentiment and confidence and solidify ourconclusion that the psychological triggers of round dollar gasoline prices and round 1,000-value DJIA effects do exist,and do matter.In this section we discuss the impact of the past two recessions, the gasoline price and DJIA trigger effects, and mostof the traditional variables on consumer sentiment and confidence.9 IHS Global Insight Published 7/1/11

Percentage ChangeConsumer SentimentConsumer Confidence10% Increase of:Relative Gas Price -1.51 -1.40SP500 Monthly Growth 3.19 6.99Initial Claims per Capita -2.05 -2.93Unemployment Rate -1.18Gasoline Price Trigger -1.40 -3.74DJIA Trigger 0.78 2.482001 Recession 0.00 3.01Great Recession Effect -3.16 -6.20Relative Gasoline Price Effect: Consumer demand for gasoline is highly inelastic, as American consumers arehighly dependent on automobiles, while gasoline prices are widely monitored and highly visible. As a result, whengasoline prices increase, households—in most cases—have little choice but to pay the additional charge to fill uptheir tanks. To do so, many consumers must dip into their savings, or make use of their credit cards. In a New YorkTimes opinion piece on July 19, 2008, Dan Ariely—a well-known behavioral scientist and professor of psychology andeconomics at Duke University—remarked that, "[w]hile we concentrate our anger on gas prices, we are ignoringincreases in electricity, food and health insurance—expenses that might actually have a greater effect on ourbudgets."A 10% rise in the gasoline price relative to the overall price level reduces consumer sentiment by 1.51% andconsumer confidence by 1.40%. Conversely, a 10% fall in the relative price of gasoline will increase consumersentiment by 1.51% and consumer confidence by 1.40%. We call this the "Relative Gasoline Price Effect," and itseffect on consumer sentiment or confidence is both continuous—it holds for any level of the relative gasoline prices—and symmetric, responding to both increases and decreases in the relative price of gasoline.Gasoline Price Trigger Effect: Gasoline prices have another effect on consumer attitudes as well, independent ofthe Relative Gasoline Price Effect. When rising gasoline prices approach and surpass round dollar values—$3.00 or$4.00/gallon—there is a sudden fall of 1.40% in consumer sentiment and of 3.74% in consumer confidence; we callthis the "Gasoline Price Trigger Effect." The Gasoline Price Trigger Effect is additional to the Relative Gasoline PriceEffect. Interestingly, when declining gasoline prices dip below a round dollar figure, there is no statistically significantincrease in consumer sentiment or confidence. While consumer reaction to rising gasoline prices surpassing a rounddollar figure is negative, they do not become more optimistic when declining prices fall below a round dollar figure.The Relative Gasoline Price Effect still operates—so consumers do become more optimistic when gasoline pricesfall—but there is no extra trigger effect. Thus, the Gasoline Price Trigger Effect is neither symmetric nor continuous.Stock Market Effect: When the stock market is performing well—as measured by the growth rate of the Standard &Poor's composite index (S&P 500)—there is an indirect impact on the household's net worth and increased optimismthat the economy and especially businesses are doing well. A 10% increase in the monthly S&P 500 index growth10 IHS Global Insight Published 7/1/11

ate adds 3.19% to consumer sentiment and 6.99% to consumer confidence. The "Stock Market Effect" is symmetricand continuous.DJIA Trigger Effect: There is another impact that the stock market can have on consumer attitudes that isindependent of the so-called Stock Market Effect and is similar to the Gasoline Price Trigger Effect. When the DowJones Industrial Average (DJIA) increases and surpasses a round 1,000-point level—for example, from 11,950 to12,150—there is an extra upward spike of 0.78% to consumer sentiment and 2.48% to consumer confidence. TheDJIA is widely followed and seems to enter consumers' psyche more readily in terms of personal milestones thanother stock market indicators.Labor Market Conditions (Initial Claims and the Unemployment Effect): Labor market conditions are a criticalcomponent to overall consumer conditions. Initial claims for unemployment insurance benefits and the unemploymentrate have a different dynamic and each impacts consumer attitudes in a negative, yet different way. A 10% increasein monthly average initial claims for unemployment benefits (per civilian population 16 years of age and older)subtracts 2.05% from consumer sentiment and 2.93% from consumer confidence. The unemployment rate does nothave a statistically significant impact on consumer sentiment; however it does on consumer confidence. A 10%increase in the unemployment rate places downward pressure of 1.18% on consumer confidence. This is easilyexplained by the prominence and importance the media places on the unemployment rate and its monthly updates.Since the unemployment rate and initial claims are lagging indicators of the economy, it is easily understood thatconsumer sentiment and confidence lag behind the Institute of Supply Management indicators and the stock marketindexes.Recessions of 2001 and 2007: The 2001 recession lasted from March 2001 to November 2001. There is nostatistical evidence that it contributed to the decline in consumer sentiment or consumer confidence when all theother factors were accounted for. However, when considered in the context of the consumer confidence index, itcontributed to a 3.01% increase during the recession period.On the other hand, the Great Recession (from December 2007 through June 2009) had a clear and statisticallysignificant effect on both consumer indexes, with reductions of 3.16% on consumer sentiment and 6.20% onconsumer confidence during the recession months. This result is consistent with previous IHS Global Insight researchinto the causes of the recessions. The 2001 recession was milder (in GDP terms) and qualitatively different from the11 IHS Global Insight Published 7/1/11

previous three downturns. It was driven by business spending rather than by housing or consumer spending, andreflected a burst bubble in the stock market. So it is not surprising that the consumer mood suffered less than normal.But the Great Recession started with housing, then spread to consumer spending, and only then to businessinvestment and exports as the global economy also went into deep recession.Even though the Great Recession was far more severe, it was consumer-led with significant consumer fatigue anddebt deleveraging.ConclusionWe have demonstrated quantitatively and qualitatively that by augmenting the traditional set of explanatory variableswith behavioral economic concepts and variables we can better understand and forecast consumer sentiment andconfidence. In a forthcoming article, we will demonstrate that inflationary expectations are not necessarily rational inthe narrow sense, but are biased, and that behavioral economics can enrich our understanding of economic behavior.by Chris G. Christopher, Jr.Please feel free to contact the author of this special report for more information on the econometric methodology,data construction, testing procedures, or other technical matters. For an overview of the history and methodology ofthe Conference Board's consumer confidence and Reuters/University of Michigan's consumer sentiment index pleaserefer to: Introduction to Consumer Confidence and Sentiment, IHS Global Insight Special Report on the U.S.Economy, Chris G. Christopher, Jr. (April 18, 2011).Footnotes:[1] Introduction to Consumer Confidence and Sentiment, IHS Global Insight Special Report on the U.S. Economy,Chris G. Christopher, Jr., April 18, 2001.[2] The General Theory of Employment, Interest and Money, John Maynard Keynes, BN Publishing, 2008, p. 161.Originally written in 1936.12 IHS Global Insight Published 7/1/11