Are the Holidays' Retail Spending Gains Sustainable?

Preliminary reports of consumer activity in the weeks leading up to the Christmas long weekend suggest a marked improvement in retail sales as compared to last year's relatively lackluster gains. According to the latest report from MasterCard SpendingPulse, November and December retail sales through December 24 were 5.5% higher than a year earlier. Retail sales were up 4.1% last year, but that result followed belt-tightening and a drop in activity in 2008. As part of a long-term structural shift, online retailers registered the largest gains this year; but bricks and mortar retailers measured significant gains, as well.

The final retail tally for December will be tempered by the blizzard that has swept through the Northeast, keeping shoppers at home during the important sales period immediately following Christmas Day. Controlling for the negative impact of the inclement weather, however, retailers can cheer that results were on the upside of expectations. Looking forward, it is unclear if these gains will be sustained or if Americans will return to their more recent modus of frugality. On one hand, the extension of the Bush-era tax cuts and the payroll tax holiday will collectively allow for greater potential discretionary spending in the New Year. At the same time, consumer sentiment remains well below the levels needed to translate a large share of after-tax income gains into actual spending.

Are the Gains Sustainable?

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

Greater confidence in the recovery has been one of the missing puzzle pieces constraining discretionary spending growth. Consumer sentiment, as measured by the Reuters/Michigan Survey, has been slow to regain lost ground. The most recent measure shows that sentiment has improved in November and December, rising to its highest level since June, but that it remains much closer to its recession bottom than to its pre-recession trend levels. Most consumers believe that the near- and medium-term improvements in the economy will be too small to positively impact job security or income. These expectations keep savings rates elevated, as does the stalled recovery in housing.

As a result of consumers' dim view of the recovery, marginal dollars have tended to feed savings rather than additional consumption. Efforts to spur investment and consumption with lower interest rates (and lower returns to saving) have failed, in part because prolonged periods of low growth and interest rates require that household increase the rate of savings for retirement given low returns on investment. This has been the case in Japan, where savings rates remain stubbornly high, in spite of negative real interest rates where savings lose value in real terms. Back at home, the savings rate remains between 5% and 6%, according to data from the Bureau of Economic Analysis. This is higher than the savings rate that prevailed during the recession and orders of magnitude higher than lows near 1 percent during the housing boom.

In sum, while we can welcome the positive holiday sales numbers, we should temper our enthusiasm with a realistic assessment of the constraints that bind consumers' willingness to grow their spending at a faster rate than their incomes. Ultimately, the key to triggering more robust consumer activity rests in meaningful improvements in the pace of job creation and consumers' expectations that improvements will be sustained. On the national stage, retail-sector outcomes are inextricably tied to the labor market. That tie calls for a restrained outlook where retail spending is concerned.