Consumer Sentiment and Consumer Spending: Decomposing the Granger Causal Relationship in the Time Domain

Abstract

It is often believed that the consumer sentiment index has predictive power for future consumption levels. While Granger causality tests have already been used to test for this, no attempt has been made yet to quantify the predictive power of the consumer sentiment index over different time horizons. In this paper, we decompose the Granger causality at different time lags, by looking at a sequence of nested prediction models. Since the consumer sentiment index turns out to be cointegrated with real consumption, we resort to Error Correcting Models. Four consumption series are studied, namely total real consumption, real consumption of durables, nondurables and services. Among other findings, we show that the consumer sentiment index Granger causes future consumption with an average time lag of four to five months. Furthermore, it is found that the consumer sentiment index has more incremental predictive power for consumption of services than for consumption of durables or nondurables, and that the index is not only useful as a predictor at the very short term, but keeps predictive power at larger time horizons.