Stephen King: Will US lose the war of nerves over consumer confidence?

The Fed cannot deliver the monetary easing that it has done in the past when confidence has collapsed

Confidence is a fickle thing. Consumers can feel confident even in the darkest of moments. Shortly after 11 September, US consumer confidence fell back but still remained at levels that were historically relatively high. This resilience was important. The consumer's willingness to carry on spending helped pull the US economy out of the recession that had hit companies very hard through the first three quarters of 2001.

Now that resilience has been broken. Last week, the Conference Board announced a collapse in US consumer confidence that, in the past, has meant only one thing: the arrival of a consumer recession (left-hand chart).

How seriously should we take this latest decline? Can we, perhaps, explain it away, put it down to the uncertainty over war with Iraq, the administration's duct tape advice and the heightened levels of security vis-à-vis the threat of terrorism? Possibly. Then again, it might have seemed reasonable to have explained away the collapse in consumer confidence that occurred in autumn 1990, just after Iraq had invaded Kuwait and just before Stormin' Norman and his friends came to the rescue. That, however, would have been a mistake. Not only was the US heading into recession but it was also entering a phase of remarkably weak growth that remained in place for another three years.

Back in 2001, Alan Greenspan summarised rather neatly the fickleness of confidence and its impact on economic activity. He said: "It is difficult for economic policy to deal with the abruptness of a break in confidence. There may not be a seamless transition from high to moderate to low confidence on the part of businesses, investors and consumers. Looking back at recent cyclical episodes, we see that the change in attitudes has often been sudden. In earlier testimony, I likened this process to water backing up against a dam until it is finally breached. The torrent carries with it most remnants of certainty and euphoria that built up in earlier periods."

Looking through his comments, I think it's safe to say that we've already had the loss of confidence from both businesses and investors. Capital spending has collapsed over the past two years and equity markets have been falling for even longer. US consumers, though, kept on going, blindly assuming that everything was going to be all right. This, after all, was the US economy, the strongest, most flexible economy in the world, the land of opportunity, the home of the entrepreneur.

And, to be fair, consumers had good reason to be optimistic. Industry was in trouble. Shareholders were panicking. From the authorities' point of view, consumers offered salvation. Persuade consumers to spend, argued the Federal Reserve and the administration, and profits will recover. And if profits recover, investment will pick up. And then we'll be back to normal.

Life, though, is rarely that simple. Consumers were likely to spend so long as interest rates fell rapidly, so long as house prices continued to rise and so long as incomes continued to be supportive. Over the past two years, the US authorities worked hard to deliver these conditions. Interest rate cuts would keep consumers borrowing. Rate cuts would also keep the housing market nicely buoyant, offsetting the loss of wealth as a result of falling equity prices. Meanwhile, George Bush's tax cuts meant that consumers would be insulated from the brutal effects of corporate restructuring.

The latest collapse in consumer confidence suggests that this approach may ultimately have failed. Policy changes over the past two years may merely have deferred America's economic problems. Moreover, encouraging consumers to borrow more over the past couple of years – the only real way in which final demand could be maintained at an acceptable level – may have made matters worse. Today, debt levels in the overall private economy – households and companies together – are even higher than they were two years ago.

Let's track back a few years to the late 1990s, to a world of bubbles. Bubbles are typically reflected in fast-growing balance sheets. Assets rise quickly in value but so do liabilities. When the bubble is in the ascendant, net wealth (assets less liabilities) tends to rise very quickly. Everyone feels richer and, hence, debt levels can rise without apparent danger. This, however, may be no more than an illusion. If the expectations incorporated in asset values prove to be overly optimistic, asset values may subsequently collapse. What had previously been an acceptable level of debt suddenly becomes totally unacceptable. And, because debt values are fixed in nominal terms, there's not a lot that the debtors can do about it apart from face the slow, unpleasant grind of debt repayment.

The policy choices of the past two years may simply have made matters worse. If debt was too high two years ago, it's higher still today. The chosen solution to an excessive debt problem has been to create even more debt. That's fine so long as the illusion of economic health can be preserved but once consumers realise that things are not quite as good as they once seemed, they're likely to pull the plug on demand. Could it be that consumers have finally recognised that a world of high debt with an uncertain economic future is perhaps a world where retrenchment is the only sensible option?

If so, the Federal Reserve has got a major problem on its hands. First, there's the obvious relationship between consumer confidence and consumer spending. Second, there's the less obvious – but hardly surprising – relationship between consumer confidence and house prices. As Ian Morris, HSBC's US economist, has argued, historic relationships suggest that house prices could be vulnerable in an environment where consumers are beginning to scale back. As the right-hand chart suggests, this could lead to falling house prices and, presumably, to a slowdown in "cash outs", the American shorthand for mortgage equity withdrawal. That, in turn, would create another downdraft for US consumer demand.

In the past, these changes in consumer confidence have been closely correlated with the interest rate cycle. Rising inflation has forced the Federal Reserve to raise interest rates which, in turn, has undermined consumer confidence. The associated fall in consumer spending has helped bring inflation down, allowing room for interest rates to fall back again. Consumer confidence then improves and consumption growth goes back to normal.

This time, the correlation has broken down. The collapse in consumer confidence has occurred not after a period of rising interest rates but, rather, after a period of particularly aggressive monetary easing. Consumers did respond at first but, like drug addicts, they're now going through a nasty period of cold turkey. Even worse – at least in the short term – there are very few drugs left to offset the shivering and cold sweats. The Federal Reserve has very little room left: interest rates are now at just 1.25 per cent. The Fed simply cannot deliver the monetary easing that it has done on previous occasions when consumer confidence has collapsed. Let's hope, then, that the collapse in confidence is no more than a "duct tape distraction" because, if it's not, the world economy is heading into very choppy waters indeed.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com