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Is it still safe to count on consumers?

American consumers have proven surprisingly resilient in recent months. But now there's growing concern that consumers won't keep propping up the U.S. economy the way they have in the past.
/ Source: BusinessWeek Online

American consumers have proven surprisingly resilient in recent months. In the face of higher gas prices, rising interest rates, and a slowing housing market, consumers have kept right on spending. That's been critical to the continuing strength of the U.S. economy, because consumers account for more than two-thirds of gross domestic product. One additional positive sign on this front came on June 27: The U.S. Conference Board reported that consumer confidence actually rose a bit in June, with its index hitting 105.7, up from 104.7 in May.

But now there's growing concern that consumers won't keep propping up the U.S. economy the way they have in the past. Why? They're beginning to understand that the changes hitting them in the wallet — from increases in gas prices to higher interest rates — may be permanent.

When prices at the pump first surged to $3 a gallon, many simply kept spending on gas and everything else they used to buy. They simply dipped into savings to make up the difference, figuring that gas prices would quickly fall. "Now they think that gas is going to remain expensive and they're making adjustments to how they spend," says Richard T. Curtin, the economist who directs a monthly survey of consumers for the University of Michigan.

The Federal Reserve meeting this week may give them even more reason for caution. When Fed Chairman Ben Bernanke and his colleagues gather on June 28 and June 29, they are expected to hike interest rates for the 17th consecutive time, by one-quarter point, to 5.25%.

There's even speculation that the Fed could boost rates by a half a percentage point, to 5.5%. Higher interest rates mean consumers pay more on credit cards, home equity, and car loans, as well as on adjustable rate mortgages.

Cheap loans
Consumer spending isn't going to collapse. People will keep spending, especially on what they deem essentials. Curtin expects personal consumption expenditures to rise between 2.5% and 2.8% over the next year, down from an average of 3% in recent quarters. "Consumers have lost their optimism for the future, but are not pessimistic yet," he says.

Americans will have to keep paying more for gas and debt, however. That means the cutbacks in certain sectors will be much sharper. Restaurants, retailers, homebuilders, and automakers are likely to be the hardest hit. Indeed on June 27, General Motors said that its sales in the U.S. will decline this year and that higher interest rates and gas prices were part of the reason. The company is offering zero-percent financing on certain vehicles for up to six years to spur sales. Ford Motor is offering zero percent financing for five years.

Homebuilders are taking it on the chin. On June 26, Lennar Corp., a Miami-based home builder, lowered its full-year earnings outlook because of an unexpected slowdown in orders. "We are experiencing slower new orders and higher cancellation rates. Consequently, the second half of the year will be more challenging," says Stuart Miller, Lennar's chief executive. Many housing stocks are down 35% to 50% from their peaks last year, including Centex, D.R. Horton, KB Homes, Pulte Homes, and Lennar.

Sluggish summer?
Conditions have become so difficult that the National Association of Realtors put out a public statement, calling on Bernanke to stop raising interest rates. "This is time for the Fed to pause on rate hikes," said David Lereah, the Realtors' chief economist.

Retailers are clearly skittish that this will be the quarter for consumers to tighten their spending. When Wal-Mart reported its first-quarter results in May, the company's executives warned that they were starting to see consumers pull back, which could affect sales over the summer. "Toward the end of the [first] quarter, we clearly saw the impact of rising fuel costs for our customer," Tom Schoewe, Wal-Mart's chief financial officer said in a conference call to discuss earnings. On June 1, the company said that same-store sales for May increased 2.3%, down from 2.7% in the year-earlier period.

Neighborhood restaurants are seeing consumers tighten their belts, too. On June 7, Brinker International, which owns the Chili's Mexican restaurants, said that sales in restaurants open at least 18 months fell 2.3% in May. That follows recent announcements by Applebee's International and OSI Restaurant Partners, which also saw sales decline in May.

Targets for trimming
Consumers are in fact more resilient than in years past. As the University of Michigan's Curtin points out, they're older, have more wealth, and have more experience with tough times. That's why they've been willing to keep up their spending so far. But he points out that they will continue to make rational decisions about when they can spend and when they need to cut back.

With their rising concerns about both recession and inflation, they're looking for places to trim their spending. Says Curtin: "We have these problems and they don't see any solutions on the horizon,"