William C Dudley: Evolving consumer behavior
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the National Retail Federation Annual Convention, New York City, 17
January 2017.
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Andrew Haughwout, Joseph Tracy and Wilbert van der Klaauw assisted in preparing these
remarks.
Good morning. It is a pleasure to have the opportunity to speak at this year's gathering of the
National Retail Federation. Retail activity plays a key role in the U.S. economy, with consumption
comprising about two-thirds of total gross domestic product. As such, understanding what is
happening in your sector is critical in assessing the economic outlook-and, with that, the
outlook for employment, inflation and interest rates. As always, what I have to say reflects my
own views and not necessarily those of the Federal Open Market Committee or the Federal
Reserve System
This morning, I will be focusing on retail spending-an important element of household
consumption. But, I will do so in a way that's perhaps somewhat different from the usual
approach, focusing in particular on the connections between housing and retail sales. I will argue
that there have been some dramatic changes that have taken place in the way that households
finance their consumption. I believe-and hope to convince you-that changes in the housing
and mortgage markets have affected the willingness and ability of households to borrow, and that
this, in turn, has had important consequences for the dynamics of consumption over the last
decade. It is an important reason why the economic recovery and expansion have been weaker
than we would like, despite the efforts of the Federal Reserve to stimulate economic activity. It
also matters as we look forward. The good news is that, while the current expansion is quite old
in chronological terms, it is still relatively young in terms of the health of household finances.
Later in my remarks, I will talk a bit about the outlook for consumer spending in 2017 and beyond.
It's worth starting off with some background in order to develop the linkage between housing
wealth and retail spending. Household incomes tend to increase as individuals grow older and
become more skilled in their work and better matched to their employers. This tends to continue
until they approach retirement age. This means that incomes are much higher later in life than
when people first enter the workforce. Ideally, households would like to be able to even out their
consumption based on their lifetime incomes, raising consumption in their early adulthood years.
In general, this would mean that young people would consume a relatively high share of their
incomes, while older people would save more. Indeed, young people might even wish to borrow
against some of their future income so that they can enjoy some of those benefits earlier in their
lifetimes.
However, there are limits on the ability to shift consumption to earlier in life through borrowing.
One problem is that lenders don't have a reliable way to compel repayment of such debts.
Consequently, the young may not have access to the credit they need to even out consumption
to the extent they would like. A pledge of assets-collateral-can help to solve this problem,
since it can be claimed by the lender in the event of a loan default.
For most households, the main form of wealth is human capital-the value of the wages that the
household members can earn over the course of their lifetimes. But human capital cannot
always be credibly pledged as collateral. For funding of educational investments, government
intervention in the form of the federally-guaranteed student loan program helps address this
problem. While private student loans exist, they typically require a co-signer with a strong credit
record. Moreover, these borrowing sources are broadly restricted to education-related spending
only.
The second most important asset on the balance sheet of many households is housing equity.
So, in addition to being a source of shelter, housing can be a major form of collateral for
borrowing for many households. In fact, for those households that have collateral available to
secure loans, housing equity is by far the most important form of collateral.
What this tells us is that the performance of the housing and mortgage markets are important to
the retail business. When home prices are rising and housing equity can easily be converted
into cash, we can expect to see relatively high levels of consumption, all else equal. Conversely,
when home prices are flat or declining, or mortgage credit is tight, this will put a damper on retail
spending. Events of the last decade have driven this point home in a very clear way.
It is well known that beginning in the mid-1990s and intensifying in the early 2000s, there was a
massive U.S. housing boom that dramatically increased the value of residential real estate in the
United States. Over the period from 1995 to 2006, the aggregate value of real estate owned by
households and nonprofits nearly tripled, rising from $8.6 trillion to nearly $25 trillion.
A remarkable, yet not widely-known, fact about this boom period is that while home values were
rising very quickly, borrowing was growing almost exactly as fast. Rather than saving the extra
wealth that was being generated by the housing boom, households were diverting a large share
of it to other purposes. Indeed, the fraction of every additional dollar of households' housing
wealth that was consumed seems to have been higher than that for financial wealth-such as
investments in equities and bonds-suggesting that they viewed the increase in home prices as
permanent.
In order to be able to assess the evolution of household finances more precisely, we worked with
Equifax-a major credit bureau-to create a new database that tracks the credit files of a
random sample of households over time. From this consumer credit panel data, we conclude
that between 2004 and 2006, households were increasing their cash flow by over $200 billion a
year by borrowing against their housing equity collateral. They supplemented that with another
$185 billion through non-mortgage borrowing. So, at the height of the boom, annual consumption
was being supplemented by around $400 billion in cash flow from debt, much of it collateralized
by housing.
As we now know, homeowners were mistaken in viewing the home price increases during the
boom as permanent. Things turned quickly as housing supply increased, home prices softened
and mortgage underwriting standards tightened sharply as credit losses on residential mortgage
lending climbed. The rise and fall of mortgage securitization activity marked by tranching
mortgage cash flows into collateralized debt obligations (CDOs) exacerbated the downturn.
Home values began to fall in mid-2006. By 2008, we saw a massive reversal in the way people
used their housing equity to finance consumption. People went from borrowing hundreds of
billions of dollars per year and increasing their mortgage debt, to paying back hundreds of billions
dollars and reducing their mortgage debt. Households deleveraged even apart from the decline
in household debt associated with the charge-offs from foreclosures. Instead of $400 billion in
net cash flow from increased borrowing, this net cash flow sharply reversed to negative $150
billion by 2010, with increased residential mortgage debt pay-down being the main source. This
rapid swing-a reduction of more than $500 billion on an annual basis-in the resources
available for household consumption was associated with a sharp and prolonged slump in
personal consumption expenditures during the Great Recession. Typically, consumption growth
slows but remains positive during a recession. In contrast, consumption actually contracted by
over $300 billion during the Great Recession.
Between 2009 and 2012, households continued paying down debt of all kinds-with the
exception of student loans, which behave differently from most other forms of consumer
borrowing. Ultimately, housing prices stabilized and began to increase again in 2012.
However, since that turning point in home prices over five years ago, something surprising has
happened. Nationally, home values have risen over 40 percent since 2012, and are now very
close to their pre-crisis levels on average-just 4 percent below their all-time peak reached in
early 2006. Most other kinds of debt-first auto, and now, credit card debt-have joined student
debt by starting to rise again, resuming their traditional role in financing consumption. The
surprising development is that housing debt has stayed virtually flat. The previous behavior of
using housing debt to finance other kinds of consumption seems to have completely
disappeared. Instead, people are apparently leaving the wealth generated by rising home prices
"locked up" in their homes.
The implications of this development have been quite significant for the retail sector. As I noted
earlier, housing debt during the boom was rising at essentially the same pace as home values,
leaving household leverage ratios more or less constant. If housing debt had risen apace with
home prices since 2012-rather than staying flat as it has-then we would once again be seeing
housing debt producing cash flows available for consumption of about $200 billion a year.
Instead, households continue to divert about $200 billion annually to paying down their housing
debt. That's a difference of roughly $400 billion per year, or about 3 percent of total consumption.
Relative to historical patterns the household saving rate currently seems quite high, given the
ratio of household net worth to disposable income.
So, why has household behavior with respect to housing debt apparently changed so much? As
always, the data reflect the result of the interaction between the demand and supply sides of the
credit market. One obvious demand-side candidate is that consumers may have become more
cautious about housing's value as a financial investment, or its value as collateral for borrowing
to finance consumption. That is, households may have come to view housing wealth as more
similar to financial wealth in that changes can be transitory rather than permanent.
Consequently, it may be viewed as prudent not to spend too much out of increases in these
sources of wealth. Additionally, the deep job losses that occurred during the Great Recession
may have also impressed on households the need for precautionary savings against adverse
income shocks.
In fact, the lessons from the housing boom and bust may have been even more traumatic.
There are many versions of this story, and most have a word like "scarring" in them. Perhaps
some potential homeowners, having seen the wild gyrations in home prices during the 2000s,
have soured on homeownership altogether. This would result in a reduced homeownership rate
due to a loss of confidence in housing as a good financial investment. Data indicate that
homeownership has declined, especially among younger workers. However, households in our
Survey of Consumer Expectations continue to report that they believe that housing is a sound
financial investment. So, the explanation for our declining homeownership rate doesn't appear to
be that homeownership has lost its luster as an investment. And, reduced homeownership
doesn't explain why people who still own homes have become less likely to tap their available
equity to finance consumption.
Other households may have been scarred by the experience of seeing their neighbors who
borrowed heavily during the boom lose their homes and have their credit ratings badly damaged.
Observing these consequences may dissuade current homeowners from making themselves
vulnerable to foreclosure by borrowing against rising home values. This would lead to an
increase in a household's precautionary demand for savings in the form of higher housing equity.
This increased equity cushion would guard against the risk that the household could find itself in
a negative equity position in the event of a future decline in home prices. With an equity cushion,
even if the household were to experience a job loss during a future housing downturn, they would
be able to sell their home, pay off the mortgage and avoid any damage to their credit.
Homeowners' desire to finance consumption by borrowing against housing equity might also be
diminished by their desire to retain their ability to move easily. The decline in home prices during
the bust eliminated many households' home equity, which is traditionally the source of down
payments for households that wish to move and remain homeowners. This mobility might be
associated with a change of labor markets or an upgrade of your home or residential location. It
is possible that households have saved their newly recovered equity in order to rebuild the
capacity to make future down payments and therefore restore this option to move. It is certainly
the case that mobility has declined since the housing bust, a fact consistent with this hypothesis.
Many homeowners also took advantage of the Federal Reserve's accommodative monetary
policy stance to refinance into very low fixed-rate mortgages. As mortgage rates rise, there is a
higher financial cost to extracting housing equity through a cash-out refinancing. The pace of
cash-out refinancing has indeed been very low even as housing equity has risen, consistent with
this hypothesis. But, owners have other ways of tapping equity, like taking out a second
mortgage or a home equity line of credit (HELOC). Interestingly, these forms of housing debt
have been paid down even more aggressively than first mortgages. So, the fluctuation in the
level of mortgage rates also does not explain the change in household behavior.
A final factor that may be reducing the demand for home equity extraction is a change in the
distribution of housing equity in the population. Even though aggregate home equity is back to
pre-crisis levels, the data indicate that the growth in equity since 2012 has gone
disproportionately to older, wealthier households. Presumably, these households have less
demand for credit to fund their consumption plans. In contrast, those who would like to convert
housing wealth into retail purchases have not yet seen their housing equity restored to its earlier
levels-reflecting, in part, slower rates of mortgage balance paydown. In addition, younger and
less credit-worthy households also experienced higher relative declines in homeownership rates.
While some of these demand-side factors seem to be playing a role in reducing home equity
extraction, there is undoubtedly a strong supply-side effect in operation as well. Our consumer
credit data indicate that lenders' adoption of minimum credit scores for mortgage lending and
their considerably more rigorous underwriting standards for HELOCs have played a very
important role in limiting consumers' ability to convert home equity into new consumption. The
drivers of this change in lender behavior are complex, but are likely to include a combination of
more regulation and stress testing of banks' portfolios, more conservative practices by the
government sponsored enterprises Fannie Mae and Freddie Mac-which tend to dictate
underwriting practices for a large part of the market-and banks' own experience from the crisis
period, when so many lenders faced extreme stress and residential real estate seemed to be the
main culprit.
The fact that housing prices declined so much and that the foreclosure process was so often
drawn out may also have caused lenders to reassess how much to rely on the housing collateral
as security for their loans. In response, lenders may have shifted their underwriting to put more
weight on the creditworthiness of the borrower rather than relying mainly on the value of the
collateral. This is consistent with the fact that mortgage credit is now much harder to get for
lower credit-rated borrowers than during the housing boom.
So, what's next? When and to what extent will households again start tapping home equity to
fund their consumption? Answers to these questions will determine the degree to which housing
equity growth will add to income growth as a fundamental driver of consumption. We do not
want to repeat the experience from the housing boom, but there are prudent ways for households
to access their housing equity.
It is hard to predict when the recent trends might change, given that some milestones have
passed that could have reignited lenders' and borrowers' appetite for home lending. First, home
prices stopped falling in 2010, which could have been taken as a signal that a complete collapse
was not imminent and that the worst was behind us, yet mortgage borrowers continued to divert
cash to paying down their debts. Second, home prices-and home equity-resumed their
growth in 2012, indicating that the market was recovering. Yet, far from extracting this equity,
borrowers continued to pay down their mortgages thereby reinforcing the effect of the home price
increases in terms of rebuilding housing equity. Aggregate home prices and home equity have
almost reached their previous peaks.
Time will tell if there is a renewed appetite, on both lenders' and borrowers' parts, to convert
housing wealth into consumption. Perhaps, we will soon see a recovery in cash-out refinancing
and in HELOC borrowing as a means for households to expand their consumption. In this case,
the household saving rate will begin to decline. Or, we may need to wait longer for households to
feel confident enough to extract some of their home equity, and for lenders to decide that
expanding such lending is safe enough for their balance sheets. Whatever the timing, a return to
a reasonable pattern of home equity extraction would be a positive development for retailers, and
would provide a boost to aggregate growth. In the meantime, consumption growth will largely be
determined by income growth, the trajectory of wages and the strength of the labor market.
The U.S. expansion is now in its eighth year. By historical standards, it is long in the tooth.
Despite this, I am optimistic that the economic expansion will continue over the next few years.
First, it is important to note that economic expansions don't simply die of old age. Usually, they
end either because inflation climbs and the Federal Reserve responds by shifting to a much
tighter stance for monetary policy, or because the economy gets hit with a large unanticipated
shock that the Fed and the fiscal authorities cannot respond to quickly enough, or with sufficient
force, to prevent an economic downturn. While economic shocks are, by their very nature,
difficult to forecast, the risk that the Fed will snuff out the expansion anytime soon seems quite
low because inflation is simply not a problem. Not only are underlying inflation trends very
subdued-for example, the core personal consumption expenditures deflator has risen at only a
1. 7 percent annual rate over the past year-but the economy is not growing much above its
sustainable long-term pace. Thus, while pressures on labor resources have been increasing,
but quite slowly. Finally, the recent strengthening of the dollar will put downward pressure on
import prices and limit the ability of domestic producers to raise their prices.
Second, the household sector's financial condition is in unusually good shape for this point in the
economic cycle. Household indebtedness is relatively low, debt service burdens relative to
household income have fallen to levels not seen since at least the early 1980s. Moreover,
household incomes are rising at a moderate pace, supported by continued job gains and some
modest strengthening of wage compensation trends. If households and lenders again become
comfortable with financing consumption with debt in addition to income, this will provide
additional support to household spending and to the current economic expansion.
The challenges in the retail space over the near term, therefore, are not likely to be a shortfall of
aggregate demand from households. Instead, it seems to me the challenges lie more in how to
satisfy households' changing demands for goods and services, and the medium through which
these demands are satisfied-whether it be brick and mortar or online. Also, there is the
important issue of how to retain brand loyalty in a world where information is ubiquitous and
always near at hand, and it is easy to shift purchases among participants in the retail
marketplace.
Thank you for your kind attention.