Tough times test battered consumers

Rapidly falling house prices and rising unemployment hit American consumers – and with savings dwindling and lenders tightening loan conditions – how much more can they take?

“The consumer is king, long live the king.” “Don’t underestimate the resilience of the US consumer.” These are long-held beliefs that have stood the test of time more often than not. Just as economists are reputed to have forecast six of the past two recessions, they have been equally remiss in their assessment of consumer spending prospects.

Maybe this time it will be different and the American consumer will be unable to prevent the economy slipping into recession. Make no mistake, without a resurgent consumer, the probability of recession increases – with adverse consequences for the rest of the world.

No matter where you look, the pressure on the consumer is getting more intense, whether that be income past, present or future – and the scope for fiscal or monetary help is equally restricted. It will be a surprise if the consumer manages to remain resilient in the face of such daunting economic head-winds.

The tax rebate scheme is past and a further possible fiscal boost is unlikely before next spring, after the new president is installed. The authorities are equally stymied on the monetary front, because of persistent inflation fears and the ineffectiveness of interest rate cuts to reduce borrowing costs.

Running down savings is not an alternative, as savings levels have already been run down to 40-year lows. They need rebuilding, not running down further. Unemployment in America has risen from a cycle-trough of 4.4% to 6.1% (see first graph), and seems likely to hit 7% before long.

Obviously being unemployed hits household incomes, but so, too, does being shifted from full to part-time – more than a million have suffered that fate over the past year. The widest measure – ‘underemployment’ – also includes those available for work but not registered, and those who have not looked for work over the past four weeks. This measure has seen a rise of 2.9m over the past eight months and stands at 12.8%.

So, shrinking hours worked squeezes disposable incomes, but so, too, does inflation. The surge in inflation this year has meant that wage growth has failed to keep up with price rises, and real income growth was negative throughout the second quarter.

A consequence was back-to-back monthly declines in real consumer spending – resilience is being tested. Although raw material and food prices have come off their peaks, they are still at elevated levels.

How about borrowing to augment present spending power? That door has been firmly shut and bolted. The credit squeeze has severely undermined lenders’ ability and willingness to lend.

Losses have reduced their capital base, so business models have had to alter. They are armour-plating their remaining capital against further loss by taking as few risks as possible, and increasing the cost of loans. Consequently, hard-pressed consumers are facing a much more hostile loan environment.

Falling house prices are removing the scope for home-equity withdrawal, by which home-owners would re-mortgage their property at the higher price and take out the extra equity. With no higher price there is no withdrawal.

Another housing-related scheme was home-equity ‘lines of credit’, whereby home-owners could borrow sums on the collateral of their house. Falling house prices reduced the potential equity and put the lender at risk. Consequently, many of the major home equity lenders have either frozen this facility or severely restricted its usage.

More broadly, lenders are generally making it more difficult to borrow. This is achieved in two ways: costand availability. For example, mortgage rates have barely moved despite a cut of three-and-a-quarter points off the key official level of interest rates, and other lenders have been equally tough (see second graph).

Availability has been restricted by making loan standards more stringent or difficult to meet.

The most recent report on lending standards reported a sharp increase, 32% to 66%, in those lenders tightening loan conditions for loans to individuals. Additionally, about half of the respondents intend to tighten further in the second half of the year, with one-third expecting to add to the tightening into 2009.

It is hoped the rescue of Fannie Mae and Freddie Mac could lead to a sustainable fall in mortgage rates. But even if it does, the odds would still be stacked against the consumer over the next year. Rising unemployment levels and a reluctance to lend will continue to handicap consumer spending.

Only when a line can be drawn under the housing debacle should the financial system be able to recapitalise and begin to re-establish a more normal credit market.

Maybe this time it is right to question the likely resilience of the consumer.