Using the Permanent Income Hypothesis for Forecasting

P ersonal consumption expenditures grew by almost 2 percent during 1993 in real, per-capita terms. Real disposable income per capita, meanwhile, actually fell slightly. By definition, households draw down their savings when consumption grows faster than income. In fact, the figures for consumption and income just mentioned underlie a decline in the personal savings rate from over 6 percent in the fourth quarter of 1992 to only about 4 percent in the fourth quarter of 1993.1 One popular interpretation of these data starts with the idea that reductions in the savings rate cannot be permanently sustained. Eventually, households must rebuild their savings by cutting back on consumption; to the extent that lower consumption leads to lower income, income must fall as well. Thus, in U.S. News & World Report, David Hage (1993–94) used the behavior of consumption, income, and savings to forecast that the economy would slow in 1994: “[A] slowdown in consumer spending is likely, and it could trim an additional 0.6 percentage point off growth” (p. 43). Around the same time, Gene Epstein (1993) of Barron’s quoted economist Philip Braverman as saying that “consumers don’t have the wherewithal to keep up the current spending pace. The prevailing euphoria will get knocked for a loop” (p. 37). Similarly, in DRI/McGraw-Hill’s Review of the U.S. Economy, professional forecaster Jill Thompson (1993) wrote: “All is not rosy, of course. Consumers went out on a limb to give the economy a needed jump-start. . . . They have pushed the saving rate very low and incurred more debt. . . . Consumption must slow” (pp. 16 and 18). In light of this conventional wisdom, which suggests that a decline in savings presages a slowdown in economic growth, the continued strength of