Trend: Higher interest rates and decreasing mortgage equity withdrawal will gradually slow consumer spending in the near future.
Barry Ritholtz writes about the forces that have been driving the economy at The Big Picture blog.
Source: The Big Picture
...the prime driver of the 2002-05 recovery has been the Fed. They slashed interest rates to 46 year lows, bringing the Fed Funds rate down to 1%, while cranking up the printing presses. Then, they kept rates low for a long time. Cheap money sent all sorts of hard assets -- oil, gold, real estate, other commodities -- soaring. This stimulus -- and not tax cuts, as Rich Lowry incorrectly claims -- was the key driver of the economy. Hey, I like tax cuts as much as the next guy, and personally benefitted ALOT from the dividend tax rate of 15% (before the AMT got me). But I calls 'em as I sees 'em, and it was historically ULTRA-low interest rates, and not the marginal change in top rates, that have been the prime domestic engine. (China was a close second, with the weak dollar right behind it).
...Mortgage Equity Withdrawal -- has gotten recognition as it put trillions of dollars into the hands of consumers, where it has been transmogrified into SUVs, new Kitchens, and HDTV plasma screens.
The mechanism for how this plays out is less well understood by Wall Street and the general public, and is slowly becoming accepted. It has begun to infiltrate the collective consciousness of investors. How the prime mechanism of the growth engine plays out, where its trending, and how it is likely to shift over time will be the key to if we ultimately end up with an economic soft landing, a hard landing, or an outright crash.
To get a sense of how important MEW is, look at what GDP would be like without it. (Pretty scary, huh?). The usage patterns of consumers is the key to understanding where this can go.
Here's where it gets tricky: Despite the rise in interest rates and the cooling of real estate, US Mortgage Equity withdrawal has remained robust.
Spending patterns following mortgage equity withdrawals. The extra MEW green in consumers pocket is typically spent over 2 to 3 quarters. That implies the $249B or so extracted in Q1 will be spent from then to Q3. If Q2 slows even more, that gets spent from then thru Q4, and so on.
Even as MEW slows, it will still be stimulative, albeit at a decreasing rate, for the foreseeable future. This will continue until something stops the spending -- most likely, a sentiment panic that freezes consumers from spending, with a religous epiphany involving saving money (hard to even imagine tho that may be).
I suspect that will occur slowly -- much later this year or early 2007. The market's action in May could even be the beginning of discounting that consumer slow down.
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Mortgage Equity Extraction, components
Bottom line: Without something else to take the place of MEW, the consumer cannot drive the US economy at these levels for very much longer. Unless business spending ramps up dramatically, there is nothing else on the horizon to take the spending baton.
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