Consumer confidence up. Will economy follow?

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    Earlier this month, Hector Gomez and his son, Sebastian, shopped for a new Dodge Ram truck at Kimberly Car City in Davenport, Iowa. A rise in consumer confidence usually suggests stronger car sales ahead, research shows.
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Consumer confidence is up. Is the consumer always right?

Well, let's say that she offers more than a good hunch, statistically speaking.

So when the Reuters/University of Michigan Surveys of Consumers reported Friday that its consumer-sentiment index rose this month, on the heels of Tuesday's reported sharp rise in the Conference Board's consumer confidence index, it's a sign that things are likely to get better three months from now.

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How good a sign? Fluctuations in these two widely followed surveys explain about 5 to 7 percent of the change in the following quarter's growth in personal consumer expenditures, according to economist Sydney Ludvigson of New York University in a 2004 paper [pdf]. Together, the surveys explain about 10 percent of the variation.

In economics parlance, that means they have "modest incremental forecasting power," she writes.

Changes in confidence also correlate with future changes in worker pay and wealth (excluding stock holdings), her study shows.

Purchases up, but which ones?

The picture gets murkier, however, when looking at specific expenditures, according to Professor Ludvigson. Combining the indexes does a fairly good job of predicting car sales but not other big-ticket consumer items, known as durable goods. For spending on services, their track record is terrible, Ludvigson's research shows. Its actually better to predict it using other measures and ignoring the indexes altogether.

Here's another conundrum: If consumers' confidence rises, then they should be spending more now, which would mean less saving and, thus, lower growth in future spending (everything else being equal). But in fact, the research says, a rise in the indexes almost always means a rise in future spending.

That would provide a nice short-term boost to the weak economy

Some caveats

But this week's surveys contain some notes of caution. While both surveys show improvement in the past three months, confidence remains at historically low levels. The Reuters/University of Michigan survey now stands at 68.7, up from 65.1 in April and 57.3 in March, but far below the level of 96.9 it registered in January 2007.

Also, the most recent Reuters/University of Michigan survey found that 36 percent of consumers – a record high – said their income had declined. "More importantly, consumers expected an overall income increase of just two-tenths of one percent, the smallest expected income gain ever recorded in the long history of these surveys," the survey's director wrote in a release.

That's very anemic growth.

So consumer sentiment is up but, to paraphrase a former president, the future could really depend on what your definition of "up" is.

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