The intrepid American consumer

ONCE UPON A TIME IN AMERICA there was a consumer society with a predictable pattern of behavior.

Consumers spent money, took on more debt and then spent more. Businesses expanded until the economy overheated. As the good times rolled, lenders became a little lax and credits weakened. To curb inflation, the Federal Reserve would raise interest rates. This caused the economy to slow. Profits fell. Layoffs spread around the nation. Consumer credit deteriorated. Lenders tightened underwriting standards and pulled back credit lines. The consumer started spending less and saving more. Household debt ratios went down.

Then, after inflation came down as the economy cooled, the Federal Reserve would reverse course and lower interest rates to get things going again. Consumers-who had denied themselves for a long time and thus had pent-up demand-began to spend again. The economy began to grow again, sometimes very rapidly. The economy had come full circle.

This time, it's different-quite different. During the long boom of the 1990s and into early 2000, the economy did not overheat and inflation was kept well under control, thanks partly to big gains in productivity. There was virtually no inflation to bring down. Another twist was this time the recession came with low interest rates, followed by further rate reductions and the beginning of a recovery.

During this recession, layoffs have not been rampant-- August unemployment was down to 5.7 percent from 5.9 percent in July. Personal income has continued to rise. Importantly, productivity not only rose during the recession; it soared during the early recovery. Credit quality has mostly held up.

"There's some deterioration in consumer credit, but it's not that significant," says Nancy Wentzler, chief economist with the Office of the Comptroller of the Currency (OCC), Washington, D.C., which oversees bank examinations.

The intrepid consumer, while cutting back last year, sharply stepped up spending in the first quarter, then slowed spending dramatically in the second. More recently, consumers resumed spending at a more moderate level in July even as the stock market plunged to a six-year low. Most economists expect consumers to continue spending at a moderate 2.5 percent to 3 percent annual pace in the coming months.

"It's not too bad, but not great either," says Stan Shipley, senior economist at Merrill Lynch & Co., New York. "One of the reasons [the recovery] will not be stronger is that usually in a recession you kill off the big consumer sectors, like housing and auto sales. Low interest rates kept both of those alive during the recession. So they will not take off as a result, so the recovery will be a little slower."

Even as economists scale back their forecasts for recovery in the second half of the year, the consumer remains king of the economy. "The strongest sectors of the economy are still tied to the consumer-housing, auto and retail sales," says Shipley. "The consumer is the driver of the U.S. economy," he adds, with rising spending by the federal government adding a little boost into the mix.

There is, however, a note of caution in the air and some worry that the economy could slip back into recession or grow so slowly it will feel like a recession. When the Federal Open Market Committee (FOMC) met in August, its members found the risks facing the economy to be "weighted mainly toward conditions that may generate economic weakness," but kept the Fed funds rate steady at 1.75 percent, a 40-year low.

The Fed's shift in bias was made partly because a string of corporate accounting scandals shook the confidence of investors and sent the stock market plummeting. The FOMC indicated that current low rates and strong productivity gains "should be sufficient to foster an improving business climate over time." While this left open the possibility the Fed could lower interest rates at its Sept. 24 meeting or later, it by no means signaled that the Fed would, in fact, do that.

After the Fed's August decision to leave rates alone, other economic reports indicated a mixture of continuing strength and some occasional signs for worry. Retail spending in July, the Commerce Department reported, rose a brisk 1.2 percent (later revised to 1.1 percent)-mostly because automakers reintroduced zero-percent financing. Auto sales rose to 1.52 million vehicles sold, a sharp 8.2 percent rise from the 1.35 million sold the previous July. The government reported U.S. retail sales in August actually rose 0.8 percent. Yet a widely watched index of consumer sentiment from the University of Michigan for September fell more than expected to 86.2 from 87.6.

It's getting harder to predict how the consumer will behave. Scratch the surface of the latest economic analyses coming from the Federal Reserve, Wall Street firms, academia and elsewhere, and you find not a little bit of bewilderment-- both at the fact that consumers kept spending during the recession and at the fact that they continue to spend at a moderate to brisk pace in the early recovery.

"I don't know what's going to happen to consumption," admits Robert Shiller, professor of economics at Yale University. The consumer's credit performance is also baffling. Notes

George Yacik, vice president at SMR Research, Hackettstown, New Jersey, "Although I have been expecting to see weakness in credit quality for some time, no, I haven't seen it yet."

The Mortgage Bankers Association of America's (MBA's) latest quarterly National Delinquency Survey reports a 12 basis point uptick in delinquencies for the second quarter of 2002, rising to 4.77 percent from 4.65 percent in the first quarter. The percentage of loans in the process of foreclosure rose 13 basis points to 1.23 percent, according to the National Delinquency Survey.

The wealth effect

While some worry that rising interest rates will slow down consumer spending and weaken consumer credit, high rates seem unlikely in the short term. A bigger worry surrounds the fallout from declines in the stock market. The market declined almost steadily from early 2000 to this summer, when it plunged briefly to its lowest point since 1998 before slowly working its way back up. It took another hit in early September and remains a very big question mark.

"There's a lot of emotion surrounding the stock market accounting scandals. I don't rule out some wealth effect asserting itself," Shiller says.

The wealth effect-a hot topic in the popular press since the big run-up in the stock market began in 1996-is a theory that consumers spend more of their current earnings during times when their assets are gaining value. When the value of those assets declines, consumers pull in spending, pay down debts and save.

There is not only debate over whether a significant wealth effect exists, but also over whether the wealth effect from stock market gains affects consumer spending differently from appreciation in home values. Throw into this mix the fact that a few minority voices have expressed worry there may be a housing price bubble that could burst and aggravate any negative effect of lower stock prices. However, the mainstream view from housing economists is that there is no housing bubble.

Economists have calculated how a poorly performing stock market might affect the economy. The White House's chief economic adviser, R. Glenn Hubbard, told Business Week in July that if we "assume that the decline we've seen since May is permanent, then you'd have GDP [gross domestic product] growing about 0.7 percent slower four quarters out."

Hubbard describes the effect of the sinking stock market as "substantial," but not enough to "derail the recovery."

At press time, the stock market had still not recovered to its May levels. The Dow Jones industrial average index fell from 10,216 on May 21, 2002 to a six-year low of 7,702 on July 23, prompting a heated discussion among market observers about whether further declines in stock values might turn the consumer so sour that the economy would fall back into recession. By mid-September the stock market had recovered a little, but remained below 9,000.

The sharp declines in the stock market during the summer were not based so much on changes in the economic fundamentals, but rather on consumer perceptions about the validity of reported earnings. "We've gone from euphoric, irrational exuberance in the markets to irrational despair," David Jones, chief economist at Aubrey Lanston & Co., New York, told the Associated Press in an Aug. 11 wire story by Martin Crutsinger. Others echo the worries expressed by Shiller that consumers will slow down spending because of the losses they've suffered in their 401(k)s. Others, however, say the wealth effect is a wash. They believe gains in home-price values make up for the losses in stocks.

David Berson, chief economist for Fannie Mae, points out that from first quarter of 2000 to first quarter of 2002, total household assets in corporate equities have fallen 33 percent or $2.85 trillion (from $8.593 trillion to $5.743 trillion), according to Federal Reserve numbers. Household holdings in mutual funds declined 7.8 percent or $257 billion (from $3.314 trillion to $3.057 trillion), a much more modest decline because of steady inflows into mutual funds from employee and employer contributions to 401(k) plans.

Looking on the housing side of the balance sheet, the total value of real estate held by households rose 19.8 percent or $2.021 trillion (from $10.212 trillion to $12.233 trillion). Thus, the $2 trillion gains in housing value were outstripped by $3.1 trillion in losses from the stock market and mutual funds.

Of course, stocks and mutual funds are not as widely distributed as household wealth, Berson notes. While 49 percent of households own equities, ownership is concentrated in the top lo percent. By contrast, 68 percent of households own homes. "What this tells us, in general, is that the rise in housing wealth is more broadly distributed than the decline in stock market wealth," says Berson. Thus, the two wealth effects essentially are a wash, he says.

What Greenspan says

Federal Reserve Chairman Alan Greenspan put some hard estimates on the differing effects of changes in wealth in a speech in August 2001 at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming. Greenspan said studies suggest between 3 and 5 cents on the dollar is spent on consumption from realized and unrealized capital gains on equities and mutual funds held by households. Greenspan added the studies also suggest that 10 to 15 cents per dollar is spent on consumption from the gain from the sale of a house (after paying off a mortgage) and from cash-out refinancing.

Based on these numbers, if you calculate the impact of the changes in household wealth, once again it comes up as a wash. That's because although the losses in the stock market have been greater than house price gains, the consumption impact estimated by the Fed is less for stocks than for housing.

Greenspan cautioned against making too much of estimates on the effect of wealth (from housing and stocks) on consumption. "Of course, these quantitative magnitudes are tentative, and a great deal of additional work will be necessary to better understand and to confirm the nature and magnitudes of the relationships between capital gains on houses and stocks-realized and unrealized-and consumer spending," he said.

Rising personal income

Greenspan, probably better than anyone, knows how important the consumer has been to this recovery. In his testimony before Congress in July, Greenspan said, "Household spending held up quite well during the downturn and through recent months, and thus served as an important stabilizing force for the overall economy."

In an accompanying policy report filed with his testimony, the Federal Reserve Board also examined the big run-up in household debt. With the consumer playing such a pivotal role in keeping the economy afloat, these debt levels are being closely watched for signs of overload.

In all of 2001 and the first half of 2002, household debt rose by 8 percent. The bulk of this debt growth was from a huge rise in home mortgage debt. However, the run-up in debt has been offset by lower interest rates and "brisk" increases in disposable income, the Fed report stated. Lower interest rates have translated into only modest increases in the cost of household debt service at the same time that higher disposable income has made it easier for households to afford the higher debt service.

Other economists have taken note of these trends as well. "The underlying trend is healthy" despite a disappointing second quarter, when GDP grew at only a i. i percent rate following a 5 percent rate of growth in the first quarter, says Sun W Sohn, chief economist at Wells Fargo & Company, Minneapolis.

"Real income is going up. We have low inflation. We have low interest rates. We have more jobs. Productivity gains are rising. In fact, productivity gains have been stunning, particularly in a recession. Productivity is the best indicator of real income gains for consumers," Sohn says.

Personal income hit $8.922 trillion in the second quarter of 2002, up $111.1 billion or 1.3 percent over the first quarter, according to the Commerce Department's national income and product accounts. This was a bigger increase than occurred in the first quarter, when personal income rose $109.5 billion.

Incomes were up sufficiently for personal saving to rise from its dismal o.8 percent in the fourth quarter of 2001 to 3.5 percent in the first quarter of 2002 and 4 percent in the second quarter. Personal consumption rose at a faster clip, 5 percent, in the first quarter, but plunged to 1. 1 percent in the second quarter, mirroring the trends in the overall economy.

Startling productivity gains

Productivity-defined as output per hour-rose 1.4 percent in the business sector in the second quarter, even though the economy slowed dramatically. Prior to the second quarter, productivity sizzled at a startling 7.6 percent rate in the fourth quarter of 2001 and an even faster spurt of 8.3 percent in the first quarter of this year.

In the first three quarters last year, when the economy was in recession, productivity rose in each and every quarter, averaging i. i percent for the year. Typically, productivity declines in a recession as layoffs continue and a lower output is spread across fixed costs. In 2000, productivity rose 3 percent. The strong gains in productivity during last year's recession and this year's recovery continue a trend that began in the late 1990s, when productivity rose dramatically above its long-- term trend of around 1.5 percent-rising to 2.3 percent in 1997, 2.6 percent in 1998 and 2.6 percent in 1999.

These gains in productivity allow the consumer to keep raising spending, as the gains are usually passed along to workers in the form of higher wages.

Pockets of weak home prices

When economists add up the reasons consumers are continuing to spend, they include prominently the fact that people still have jobs and that unemployment has not risen to the levels one would expect in a recession or even during an early recovery. Unemployment fell to 5.7 percent in August from 5.9 percent in July, and the economy added 39,000 jobs.

Continued steady employment is key to a number of factors that could affect the other pillar of household wealth-- home-price appreciation. To the extent people have jobs, they can hold onto their homes. If there are heavy layoffs, homeowners may flood the real estate markets with an excess inventory of homes, pushing down home prices.

Where unemployment has risen in the current economy, such as in the high-tech sector, there has been stagnation or decline in housing prices where such businesses are concentrated. Currently, San Francisco and San Jose, California, lead the way in softening home prices, due to the collapse of many dot-com firms in Silicon Valley. Other high-tech areas such as Austin, Texas, are seeing similar effects.

The San Francisco Bay area is likely to continue to lead the nation in weak home prices during the coming year, according to a survey by Fiserv CSW Inc., Cambridge, Massachusetts. The firm predicts the weakest metropolitan market will be San Jose, where average home-sale prices will decline slightly. The next weakest market will be the San Francisco metro area, where prices will be flat (see Figure 1).

Rising unemployment

Over the summer, layoffs and bankruptcies in the airline industry and retailing spread job losses around the country, albeit at a modest level. Even so, unemployment was down slightly in August at 5.7 percent (from 5.9 percent in July). The U.S. economy gained 39,000 jobs for a total nonfarm payroll of 130.8 million. Since April, nonfarm jobs have grown by 162,000. Between March 2001 and April 2001, however, 1.78 million jobs were lost.

Typically unemployment continues to rise during the early part of a recovery. Does this mean higher unemployment is in the wings? Yes, says Doug Duncan, MBAs chief economist-- but not because of layoffs.

Unemployment will rise to a level around 6.1 percent to 6.2 percent because the number of people in the work force is growing faster than the economy can add jobs, according to Duncan. Part of the reason jobs are not being added very fast, Duncan explains, is that capital spending by businesses has not bounced back. Importantly, profits need to recover before capital spending can increase. So far, profit recovery has been modest. For this reason, "companies will not add new jobs as fast as they ordinarily would in a recovery," he says.

Companies also need to see their share prices rise, Duncan adds. How do higher share prices help? They allow corporations to leverage their capital spending, Duncan says. They can pledge their stock and increase their borrowing power, he explains, and higher valuations also lower the cost of new capital by improving a company's credit rating.

Businesses are also holding back, according to Duncan, because they are worried about further political fallout in Washington from the accounting scandals and the corporate governance crisis that captured the nation's interest over the summer. So far, Congress has passed a tough new accounting law that helped ensure that boards of directors are independent. Accounting firms will be overseen by a new federal agency. In addition, Securities and Exchange Committee (SEC) Chairman Harvey Pitt required chief executive officers to certify their companies' earnings by August 14, a step that market observers say helped improve confidence in the markets and helped begin a recovery from the stock market's sharp decline.

Higher savings, slower consumption

The need to save more money for retirement could also be a factor holding back the pace of the current recovery. The 72 million Americans born between 1946 and 1964 are in their peak earning years. The oldest baby boomers are already 56 and turn 62 in 2008.

"Boomers have seen quite a reduction in their wealth in stock portfolios" in and out of their 401(k) plans, Duncan says. If boomers hope to continue to meet their goals for attaining a certain level of wealth in retirement-goals established before the stock market slump-"they may now say we have to save more, and we may see the saving rate rise from 4 percent, and consumption could fall as a result of that," Duncan says.

Concern about adequate retirement savings may also lead boomers to shift from 30-year to 15-year mortgages, according to Duncan. Looking at the declines in their stocks and mutual fund holdings, boomers may want to make sure they pay off their mortgages before they enter retirement.

There is, in fact, a shift under way from 3o-year mortgages to 15-year loans, Duncan says, based on his own informal survey. Freddie Mac Chief Economist Frank Nothaft says when interest rates are low more borrowers typically move into 15-year mortgages. He says this is especially true when there is a pronounced and growing gap between rates for 30-- year and 15-year mortgages, which has recently been the case.

Rising debt levels

One of the clouds on the economic recovery horizon is a rise in household debt levels. Current levels are approaching historic highs as a percentage of consumer wealth, yet few are making much of an issue of it.

As Greenspan noted, debt service is rising only modestly because of low interest rates and the use of mortgage refinancings to consolidate other debt. According to the Federal Reserve, household debt service payments as a percentage of disposable personal income fell slightly in the first quarter of 2001 to 14.05 percent, down from 14.32 percent in the fourth quarter. One has to go back to the fourth quarter of 1986 to find higher debt service levels of 14.38 percent, according to the Fed.

In recent years the amount of household debt service represented by mortgage payments has crept up, while other debt service has remained about the same. In the first quarter, for example, mortgage debt service was 6.2 percent of disposable personal income, while other consumer debt service was 7.85 percent.

A report earlier this year from UBS Warburg, New York, notes some consumer debt trends that it finds worrisome. For one thing, consumers "spent" all the gains from the interest rate cuts made by the Federal Reserve last year, says Gary J. Gordon, managing director in the financial services group of UBS Warburg. In other times of interest rate reductions, such as 1998 and 1992 to 1993, consumer debt burdens fell after the Fed reduced interest rates. Indeed, both during the recession and now during the recovery consumers are running up debt faster than they are making gains in personal income, Gordon contends.

UBS Warburg's report noted that inevitably higher interest rates will push up the debt burden on some consumers, even without additional increases in debt. When rates rise, consumers will see higher rates in their adjustable-rate mortgages, and consumer loan rates will rise. UBS Warburg predicts that the mortgage debt burden, which stood at 6.4 percent of personal income at the end of 1998, will rise to 7.6 percent sometime next year. Gordon predicts auto debt may decline, however, as car sales-which have been growing rapidly with zero-percent financing-will decline. Credit-card debt growth, on the other hand, will grow slowly, he says, averaging an increase of between 2 percent and 4 percent next year.

High debt levels also suggest that consumers will be cutting back in the future, thereby slowing the economy, Gordon predicts. "Historically, the higher the debt burden, the lower the debt burden growth and the higher the credit risk," he says. While this trend is likely to repeat itself, according to Gordon it is difficult to say exactly when the slowing debt growth and worsening credit effect will kick in.

"There is no automatic trigger"-a certain level of debt to disposable income-"where everything blow ups," Gordon says. This outlook should make lenders "a little more cautious at the margin in their underwriting," he says, demanding more collateral, for example. Delinquencies have nowhere to go but up, he contends.

One of the reasons that delinquencies have not risen more is the heavy refinancing of mortgages that occurred last year and this year. Loans normally must season a few years before delinquencies start to climb. Problems have been showing up already for Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans. Those loans carry average delinquency rates of ii.81 percent and 8 percent, respectively, according to MBA's National Delinquency Survey. Other pockets of rising delinquency include some subprime markets.

Mortgage lenders across the board have been approving more mortgages where the borrower has higher total debt ratios (mortgage plus other debt service) than has been standard in the recent past. More of the mortgage loans from lenders that are clients of mortgage insurer United Guaranty Corporation, Greensboro, North Carolina, have total debt ratios higher than 40 percent. United Guaranty, for example, reports that 67 percent of its loans this year have a total debt ratio of less than 40 percent, a slight reduction from 68 percent last year and a further drop from the 71 percent levels of 1999.

United Guaranty is finding that the delinquency rate on mortgages with debt ratios higher than 40 percent is 1.4 times higher than the ratio on mortgages with debt ratios below 40 percent, according to Len Sweeney, United Guaranty's senior vice president of credit policy and insurance operations. United Guaranty did not provide the delinquency numbers for the two categories. "Although this has not caused us to re-examine our underwriting guidelines or change execution, this segment of business [with debt ratios over 40 percent] is one we are watching closely," says Sweeney.

Overall, despite higher debt ratios, delinquencies for mortgage loans have risen moderately considering the economic downturn. In the second quarter the delinquency rate for loans on one-to-four-unit residential properties was 4.77 basis points, 12 basis points higher than the previous quarter, according to MBA's National Delinquency Survey. Delinquencies remain relatively contained, in part because of the gigantic $1.117 trillion refinancing wave in 2001, which represented 55 percent of the overall record-breaking $2.030 trillion mortgage market last year, says MBA's Duncan. As a result of the refi wave, "loans moved out of the FHA and VA categories that have much higher delinquency rates and into the conventional loan category with a much lower rate-- thus, the drop in the overall rate," Duncan says. Delinquencies for FHA loans rose to ii.81 percent, up 58 basis points, while the rate for VA loans rose by 31 basis points to 8 percent, according to MBAs National Delinquency Survey.

Most of the rise in household debt, as noted earlier, is due to an increase in the amount of mortgage debt. Some of this represents new homeowners entering the market who previously were renters and had no mortgage debt. Much of the rest is from sales of current homes-where mortgages for the borrower typically rise significantly over the mortgage held by the seller-and refinancings.

Not to worry about debt loads

Some economists see worries about this increase in mortgage debt as much ado about nothing. "It's hard to make a case that it matters too much," says Merrill Lynch's Shipley. "Mortgage debt goes up because consumers feel good about the economy. They cut back on debt when they are concerned. You can't find a case of debt going up when consumers are worried about the economy," Shipley says.

Robert Van Order, the international economist at Freddie Mac, for example, claims rising mortgage debt in the last two years has had "a stabilizing effect on the economy." He estimates that $100 billion from cash-outs in last year's refinancing wave added i percent to the GDP. Whether the money was used to consolidate debt, finance home improvements or for outright consumer spending, refis have helped consumers better manage their finances, he maintains. In some cases, adjustable-rate mortgages were converted to fixed rates. In other cases, consumers used cash-out from refis to reduce overall payments on outstanding debts. And in still others, monthly payments were lowered, giving consumers a larger disposable income stream each month, Van Order says.

Dean Maki, vice president and economist at Putnam Investments, Boston, co-authored with Peter J. Brady and Glenn B. Canner a study of mortgage refinancings for the Federal Reserve. The study was based on answers to questions the Fed sponsored on the March through May 1999 Surveys of Consumers done by the Survey Research Center of the University of Michigan.

The study found 92 percent of those who refinanced obtained a lower interest rate, with an average decline of 130 basis points from 8.4 percent to 7.1 percent. About 35 percent of homeowners who refinanced in 1998 and early 1999 used the opportunity to take cash out of their home equity. The survey found that one-third of the money was spent on home improvement, one-fourth to pay off other debt and one-fifth for consumer spending on such things as cars, vacations, education and medical expenses. One-fifth was used to invest in real estate or business and less than 2 percent was spent to invest in the stock market. Cash-out was used for home improvement by 40 percent of those who refinanced.

Maki, for one, disputes that the cash taken out from home refinancings adds to the economy by anywhere near the magnitude cited by Freddie Mac's Van Order. The biggest impact of cash-out refis is clearly on the balance sheet, he notes. The amount spent on consumption from last year's refis would add only between o.1 percent to 0.2 percent to the rate of growth of consumer spending, says Maki. If consumer spending were growing at 4 percent without refis, then refis would push it up only to 4.1 percent or 4.2 percent, he says.

Such spending may, however, be a big boost in some categories, such as spending at stores like Home Depot and Lowe's that sell home-improvement products. Wal-Mart and department stores saw almost nothing in the late 199os or over the past year in additional consumer spending from refis, Maki says.

Back to that wealth effect

Maki takes a distinctly contrarian view about the wealth effect from housing compared with that from the stock market. "The stock market equity wealth effect has a much greater impact than the house appreciation wealth effect," he says. He cites government data on the rate of growth in consumer spending to make his case.

During the boom years of the late 199os, when the stock market was soaring, consumers were spending at a 5 percent annual clip. However, the rate fell to 4.2 percent in 2000 and then to 3.1 percent in 2001-during a time that home prices were accelerating rapidly and stock prices were falling. For the first quarter of 2002, consumer spending was 3.2 percent. "That's about the right magnitude of deceleration we expected from our estimates of the equity market effect," Maki says, referring to two 2001 studies of the wealth effect he did with two Federal Reserve economists.

Maki contends the stock market wealth effect has the greater impact because the top quintile of consumers, those with the greatest equity holdings, accounted for 46 percent of consumer spending in 2001. For the remaining 80 percent of the population, their home is more valuable than their equity holdings. Yet, the impact of housing wealth appreciation on spending is less than equity wealth, he says, making the impact of the bottom 8o percent of consumers "a wash" when you throw in declining equities and rising home values.

Why is this important? Because the consumer is driving economic growth right now, and how wealthy consumers feel going forward will largely dictate how prone they are to spend.

That leaves the equity wealth effect of the top quintile of consumers as the defining one for the economy according to Maki.

The importance of home-price appreciation, contends Maki, is that it is rising in tandem with the total mortgage debt outstanding for consumers. Thus, while debt is rising, it is not rising faster than the value of homes-so increases in mortgage debt should not be viewed as a problem.

Other economists agree. "I view housing debt as an investment," says Wells Fargo's Sohn; however, Sohn disagrees with Maki's conclusion that the stock market wealth effect has a greater impact than the home value wealth effect.

In recent Fed surveys, the average consumer had only $11,500 in stock holdings, including 401(k)s, says Sohn. "You have to get to the 95 percent income distribution before stocks are more important than real estate. For the vast majority of Americans, house wealth is greater than stocks."

Sohn dismisses Maki's contention that the top earners account for nearly half of total consumer spending. "There are only so many Mercedes-Benzes and big houses one can buy," says Sohn. The real numbers in consumer spending do not come from those categories, but from consumers "hitting the malls," he says.

Consumers feel more like spending when their home values rise, because it represents more of their wealth and they feel that increases in home values are more likely to be permanent than those in the stock market, according to Sohn.

What next?

There are doubts that consumer spending can go on indefinitely-even in the housing sector, which has been so strong. Consumers may reach a point where they cannot tap much more of their home equity as house prices reach a peak, says Merrill Lynch's Shipley.

But at press time there appeared no end in sight for the booming pace of the housing market. In July, new homes hit a record 1.02 million units annual pace, according to the National Association of Home Builders (NAHB), Washington, D.C., with no sign of overbuilding.

If current trends hold up, new-home sales and existing-home sales should both set records for the year, according to David Lereah, chief economist of the National Association of Realtors (NAR), Washington, D.C. Lereah expects existing-home sales to hit a record number of 544 million for the year and new-home sales to rise to 920,000.

"There's virtually no risk now that we'll see any shift from the current low level of interest rates, and we don't expect the 3o-year fixed mortgage interest rate to rise above 7 percent until sometime next year," says Lereah.

"The only sign of a slowing in the housing market has been a decline in housing starts, which declined 2.7 percent in July, following a similar decline in June. Even so, total housing starts for the first seven months are still up by 3.8 percent over the previous year," says Lereah.

Lereah expects that while the housing market still favors sellers, the inventory of homes is likely to rise in the second half of the year. This should take pressure off home prices, which he expects to rise only modestly next year. There's no chance of a national housing bubble in this scenario, he adds.

So the stage seems set for the intrepid American consumer to continue driving the economy, albeit at a modest pace. Housing will likely remain the consumer's strongest mode of powering the economy. Should corporate profits recover and investor confidence rebound from current low levels, business capital spending could give a welcome boost to the economy's workhorse consumers.

All this assumes no new major disruption to the economy. One big uncertainty is talk of a possible war to topple Iraq's Saddam Hussein.

Leaving aside such extraordinary events, the intrepid consumer is likely to forge ahead as the strongest force in the US. economy. Low interest rates, rising productivity and rising personal income have been a powerful ally to steadfast consumers as they continue to sustain the recovery.