A new era of earnings-led consumption growth?

After the U.S. housing bubble burst in 2007, many economists and policymakers claimed that the United States could no longer depend upon credit growth to boost consumption and economic growth. Investment and earnings would have become the foundation for future increases in personal consumption. It seems that part of that recommendation may be coming true. Personal consumption appears to be now strongly linked to earnings growth, a relationship that could have important implications for the future pace and stability of economic growth.

Late last week, Bloomberg News reported on an analysis of consumption growth by Tom Porcelli, the chief U.S. economist for RBC Capital Markets. The analysis looked at the correlation between the growth in earnings, specifically total weekly payrolls, and consumption growth. Porcelli finds that correlation during the current economic expansion, from June 2009 to today, is 0.9, a very high correlation. Compare that to the correlation for the expansion from late 2001 to late 2007, which was just over 0.1. This weak relationship between consumption and earnings growth during this earlier period makes sense as this was when the housing bubble was inflating.

Porcelli’s results indicate that consumption and earnings growth are currently tightly linked. Looking at the growth in weekly payrolls over the past two expansions, the difference in the rate isn’t that large. For the expansion between November 2001 and December 2007, the growth rate in payrolls was 4.12 percent on an annual basis. For the most recent expansion, June 2009 to today, the average annual growth rate is 4.09 percent. Yet there’s a significant difference in the growth rate of consumption. For the previous expansion, the average annual growth rate in inflation-adjusted personal consumption expenditures, or PCE, was 2.8 percent. Yet, with roughly the same payroll growth, the average annual growth rate in PCE for this expansion now stands at 2.3 percent, a full half percentage point lower, though of course the current expansion has yet to run its full course.

A dig into the data shows that the decline in consumption powering economic growth is about the growth in the consumption of nondurable goods (food and clothing) and the consumption of services (healthcare and transportation). In the 2001-to-2007 expansion, consumption of nondurable goods grew at a 2.6 percent average annual rate and services grew by 2.5 percent. In the current expansion, the average rates are 1.9 percent and 1.8 percent, respectively. And as economists Atif Mian of Princeton University and Amir Sufi of the University of Chicago noted last year, nondurable and services PCE growth is historically weak during this business cycle.

Earnings growth over a recovery intuitively seems more connected to nondurable and services rather than durable goods. The reason: Durable goods (a car or a dishwasher) are often large essentials for a household whereas nondurable goods and services are more likely to be expenditures that are not critical for the maintenance of life. Households could hold back on these expenditures if earnings growth isn’t as strong.

Personal consumption is about 70 percent of the total U.S. economy, so understanding the changing determinants of consumption growth is critical. If consumption is more earnings-led and earnings growth picks up, then the result would be more sustainable and equitable growth. But if it doesn’t pick up then consumption growth may become permanently lower. So either consumption would become a lower share of total economic growth or total growth slow down. Any of the above scenarios would be a stark and important change for the U.S. economy.