RDP 2016-10: The Effect of Consumer Sentiment on Consumption 1. Introduction

Household consumption accounts for more than half of national expenditure, making it important from a macroeconomic policy perspective to understand its behaviour. Changes in expectations about future economic conditions are thought by many to be an important source of variation in consumer spending. These changes may appear as innovations to consumer sentiment indices. Accordingly, consumer sentiment measures are believed by many to be both prognostic and causal. Some policymakers have expressed support for this view (Stevens 2011; Yellen 2015). Among academic economists, Blanchard (1993) and Hall (1993) have argued that an autonomous drop in consumption – foreshadowed in consumer sentiment – was an important contributor to the 1990–91 recession in the United States. Consistent with these views, there is a sizeable correlation between consumer sentiment and consumption growth (Figure 1). However, many economists remain sceptical about the information contained in consumer sentiment indices. The correlation between sentiment and consumption growth could reflect a common factor, such as changes in current income, that independently influence both sentiment and consumption, rather than sentiment having any causal effect on consumption. Typical of this view, Milton Friedman (1992, p 523) argued that ‘They [consumer confidence indices] are mostly a reflection of what's going on rather than a cause’.

In general, it is difficult to identify whether changes in consumer sentiment have a causal effect on consumption because it is challenging to find variation in sentiment that is unrelated to variation in fundamental determinants of economic conditions. However, in this paper, we are able to consider cross-sectional variation in sentiment related to individuals' political preferences to isolate variation that is plausibly unrelated to changes in current fundamental drivers of consumption. We use individual responses from the Australian consumer sentiment survey because it is unique in asking individuals' about their voting intentions. We document that consumers report substantially higher levels of sentiment when their political party holds office at a federal level compared to those who support the opposition party. This can be seen in Figure 2, which shows the consumer sentiment index separately for supporters of the two major political parties in Australia: the Australian Labor Party (ALP) and the Liberal/National party (LNP). Over the period for which we have aggregate-level consumer sentiment data, there were four federal elections which resulted in a change of government: 1983, 1996, 2007 and 2013. These elections are represented by vertical lines in the figure. Strikingly, the difference in sentiment between these two groups of voters is large and it changes dramatically at elections for which there is a change of government, and is then sustained for the entire period each political party holds office.

The sharp and discrete change in sentiment at changes of government – which in our sample have not coincided with major economic events – indicates that the variation in sentiment we exploit is unlikely to be related to changes in current or past fundamental drivers of consumption. Furthermore, the timing of the shifts in sentiment at changes of government indicates that the variation reflects political preferences affecting economic beliefs rather than perceptions of current economic conditions affecting political preferences. Thus, we believe these shifts in sentiment around changes of government are more likely to represent pure sentiment than unbiased beliefs about future changes in incomes.

Our identification approach differs from much of the existing literature on consumer sentiment, which has mostly considered time series data and a control variable approach in seeking to identify whether changes in sentiment have a causal effect on consumption. Carroll, Fuhrer and Wilcox (1994) and Ludvigson (2004) find that after controlling for economic fundamentals – measured by labour income growth, stock prices and short-term interest rates – sentiment contains some small but statistically significant independent information about future consumption growth. But it is unclear what additional information is contained in consumer sentiment. The incremental predictive power of sentiment could reflect current or past events embedded in other fundamental determinants of consumption that have not been accounted for, rather than any independent causal effect of changes in sentiment on spending (Ludvigson 2004). We believe our identification approach has two important advantages relative to this approach: first, by using cross-sectional data we remove all aggregate economic shocks that affect both sentiment and consumption, and; second, by using variation in sentiment caused by changes in government, rather than the residual-based approach of the time series literature, we can be more confident that the variation we use is independent of changes in fundamental determinants of current economic conditions.

We use two consumption indicators to estimate whether the shift in sentiment between ALP and Liberal/National voters at changes of government has a causal effect on consumption. First, we use self-reported spending intentions for a major household item, which is asked as part of the consumer sentiment survey, allowing us to match reported sentiment, political preferences and spending intentions at the individual level. Second, we use new motor vehicle sales to households by postcode, which we relate to postcode-level variation in vote shares. Motor vehicle sales are well suited for our purposes, being an important spending decision for most households.

Using the self-reported spending intentions data, we show that consumers report significantly more positive spending intentions when the political party they support is in government. The shift in spending intentions coincides with each of the three changes of government for which individual response data from the consumer sentiment survey are available: 1996, 2007 and 2013. To estimate the causal effect of changes in sentiment on spending intentions, we focus on the period around each change of government and at the individual level regress reported spending intentions on sentiment, using voting intention as an instrument for sentiment. This approach considers only variation in beliefs related to political preferences to identify the effect of sentiment on spending intentions, which we argue is variation unrelated to changes in current fundamental determinants of consumption. We estimate that an increase in sentiment causes consumers to report significantly more positive spending intentions.

Our postcode-level consumption indicator allows us to assess whether the spending intentions data map to actual consumption behaviour. The new motor vehicle purchases data we use span two changes in government, from the Liberal/National party to the ALP in 2007, and back to the Liberal/National party in 2013. Consistent with the spending intentions data, we find that new motor vehicle purchases by households increased in ALP postcodes relative to Liberal/National postcodes following the ALP victory at the 2007 election, and that new motor vehicle purchases by households fell in ALP postcodes relative to Liberal/National postcodes following the change of government from the ALP to the Liberal/National party at the 2013 election. This provides, we believe, some of the first evidence matching survey-based spending intentions data to actual behaviour.

Our cross-sectional approach implicitly controls for economy-wide shocks. But political preferences could be correlated with economic variables, and it is possible that economic shocks to specific occupations or to parts of the income distribution influence consumption independently. To control for this, we regress the share of votes for the ALP by postcode on a large set of postcode-level economic variables and use only the variation in postcode-level vote shares that cannot be explained by economic controls as our source of cross-sectional variation. The results are qualitatively similar.

Our paper makes several contributions to the literature. First, by exploiting geographic variation in consumer sentiment and new motor vehicle purchases, we are able to assess whether self-reported spending intentions match actual behaviour. Our results provide support for the usefulness of spending intentions elicited from surveys, and more generally speaks to the literature on the usefulness of opinions elicited in survey and experimental settings (e.g. Levitt and List 2007).

Second, our paper provides evidence that consumer sentiment has a causal effect on consumption. The sharp change in sentiment between ALP and Liberal/National voters at elections, which is unlikely to be related to a change in current fundamentals, precedes changes in spending intentions and new motor vehicle purchases for the two groups. The earlier literature has largely been unable to identify whether the information contained in consumer sentiment mostly proxies current and past fundamentals contained in other macroeconomic series, or contains independent information about future consumption plans. This is because they did not have access to cross-sectional variation that is likely to be independent of economic fundamentals, such as political preferences.

Third, our results provide a basis for believing that changes in pure sentiment can affect consumption. Disagreement between ALP and Liberal/National voters is evident in expectations for both personal and general economic conditions. Differences in beliefs about personal economic conditions could be mutually consistent, possibly reflecting distributional effects of government policy. But both groups of voters cannot be correct in their disagreement about changes in general economic conditions. Thus, the disagreement about general economic conditions between ALP and Liberal/National voters is, from the point of view of an outside observer, more likely to reflect noise than news about fundamentals.^[1] Reinforcing this, the political science literature has documented that differences in political affiliations can affect how individuals perceive even past economic events (Bartels 2002). Thus, our results suggest an expansive view of sentiment, providing empirical support for recent theoretical models that highlight a role for non-fundamental drivers of consumption (e.g. Lorenzoni 2009; Angeletos and La'O 2013).

Our paper is most similar to Mian, Sufi and Khoshkhou (2015), who use US data to show that consumers report more positive views about government economic policy when the political party they support controls the Presidency. We provide comparison between our findings and theirs in Appendix A.

Footnote

Barsky and Sims (2012) have argued that consumer confidence is likely to reflect information about future productivity rather than ‘animal spirits’. We do not believe that our results are inconsistent with theirs. They argue that changes in animal spirits cannot lead to long-lived changes in consumption because animal spirits do not affect an economy's productive capacity. Here we have two groups of consumers, so autonomous movements in consumption need not affect the productive capacity of the economy if the consumption of one group of consumers offsets the other. [1]