Preliminary reports of consumer activity in the weeks leading upto the Christmas long weekend suggest a marked improvement inretail sales as compared to last year's relatively lacklustergains. According to the latest report from MasterCard SpendingPulse, November and December retail salesthrough December 24 were 5.5% higher than a year earlier. Retailsales were up 4.1% last year, but that result followedbelt-tightening and a drop in activity in 2008. As part of along-term structural shift, online retailers registered the largestgains this year; but bricks and mortar retailers measuredsignificant gains, as well.

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The final retail tally for December will be tempered by theblizzard that has swept through the Northeast, keeping shoppers athome during the important sales period immediately followingChristmas Day. Controlling for the negative impact of the inclementweather, however, retailers can cheer that results were on theupside of expectations. Looking forward, it is unclear if thesegains will be sustained or if Americans will return to their morerecent modus of frugality. On one hand, the extension of theBush-era tax cuts and the payroll tax holiday will collectivelyallow for greater potential discretionary spending in the New Year.At the same time, consumer sentiment remains well below the levelsneeded to translate a large share of after-tax income gains intoactual spending.

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Are the Gains Sustainable?

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In the most basic model, improvements indiscretionary consumer spending depend upon a combination of growthin employment and employed persons' income, confidence in thestability of the future income stream (i.e. job security), risingwealth levels, and access to reasonably-priced credit. In thismodel, absent growth in overall employment, spending economy-widecan still rise if incomes are rising or confidence is improving,shifting dollars from savings to consumption. Spending can alsorise if house prices are rising, driving a wealth effect as wasobserved during the housing boom. In a less likely scenario,spending can fall even if the jobs picture is improving, in theevent that stronger employment trends coincide with fallingconfidence. This scenario might result from an uptick in consumers'inflation expectations.

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Greater confidence in the recovery has been one ofthe missing puzzle pieces constraining discretionary spendinggrowth. Consumer sentiment, as measured by the Reuters/MichiganSurvey, has been slow to regain lost ground. The most recentmeasure shows that sentiment has improved in November and December,rising to its highest level since June, but that it remains muchcloser to its recession bottom than to its pre-recession trendlevels. Most consumers believe that the near- and medium-termimprovements in the economy will be too small to positively impactjob security or income. These expectations keep savings rateselevated, as does the stalled recovery in housing.

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As a result of consumers' dim view of the recovery,marginal dollars have tended to feed savings rather than additionalconsumption. Efforts to spur investment and consumption with lowerinterest rates (and lower returns to saving) have failed, in partbecause prolonged periods of low growth and interest rates requirethat household increase the rate of savings for retirement givenlow returns on investment. This has been the case in Japan, wheresavings rates remain stubbornly high, in spite of negative realinterest rates where savings lose value in real terms. Back athome, the savings rate remains between 5% and 6%, according to datafrom the Bureau of Economic Analysis. This is higher than thesavings rate that prevailed during the recession and orders ofmagnitude higher than lows near 1 percent during the housingboom.

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In sum, while we can welcome the positive holidaysales numbers, we should temper our enthusiasm with a realisticassessment of the constraints that bind consumers' willingness togrow their spending at a faster rate than their incomes.Ultimately, the key to triggering more robust consumer activityrests in meaningful improvements in the pace of job creation andconsumers' expectations that improvements will be sustained. On thenational stage, retail-sector outcomes are inextricably tied to thelabor market. That tie calls for a restrained outlook where retailspending is concerned.

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Dr. Sam Chandan

An irreverent take on the macroeconomic environment. Dr Sam Chandan is President and Chief Economist of Chandan Economics and an adjunct professor in real estate and public policy at the Wharton School of the University of Pennsylvania.