September 26, 2013
Why Have Americans' Income Expectations Declined So Sharply?
Data from the Thomson Reuters/University of Michigan Surveys of Consumers (Michigan survey) suggests that Americans' income expectations declined sharply in the 2008-09 recession and remain depressed. The reasons for this marked increase in pessimism are important because theory suggests that income expectations are a fundamental determinant of consumer spending and may help us understand the slow economic recovery.
In this article, I examine two related questions about income expectations:
- Was the decline concentrated among households with certain characteristics, or was it much more widespread in the population?
- Did the decline reflect the more adverse experiences of certain households, or was it reflective of a more general malaise?
I used the monthly individual-level data from January 2007 to April 2012 in the Michigan survey to answer these questions.1
Large, Persistent Drop in Income Expectations
The first chart plots the survey responses to the following question on nominal income expectations: "During the next 12 months, do you expect your (family) income to be higher or lower than during the past year?"
As shown by the black line--from the start of the series in the late 1970s until 2007--on average, 60 percent of respondents expected their family income to be higher over the next year. The percent expecting higher income typically dipped in earlier recessions (the gray bars), but the decline in the last recession was much larger and has been much more persistent. The percent expecting lower income (the red line) reached an unprecedented high level in the last recession and has remained elevated. The responses to a separate survey question about real income expectations (not shown) display a similar pattern.
Pessimism Seen across a Wide Range of Households
The recent drop in income expectations does not appear to be limited to a select group of households. The summary measure of income expectations used here is the diffusion index, or the percentage of respondents expecting higher income minus the percentage expecting lower income plus 100. The left panel in the second chart shows that income expectations fell sharply in the recession for all levels of education. The decline was somewhat larger for individuals with less education (the red and black lines), but by the first half of 2012 the income expectations of all education groups were comparably depressed relative to their pre-recession levels.
The right panel shows the differences in income expectations by age. The data indicate that income expectations declined in all age groups. Interestingly, the income expectations of households headed by individuals over the age of 60 (the red line) also fell sharply, suggesting that the weak labor market, at least directly, may not be the only reason for the increased pessimism. This decline in expectations across all education and age groups, as well as similar patterns (not shown) in income expectations by gender, marital status, and position in the income distribution, point to a widespread decline in income expectations over the past several years.
Income Expectations Vary by Financial Experiences or Circumstances
There is a strong relationship in this survey between individuals' recent financial experiences and their income expectations. Income expectations are substantially higher for households who consider themselves to be better off financially than for those who are worse off financially. While this may seem obvious, if a household viewed their recent financial setback to be temporary, they might be even more likely to expect higher income growth than a household whose finances had improved recently.
Within each group of financial experiences--the "better-offs" and "worse-offs"--there is only a modest decline in average income expectations from 2007 to 2012. However, as is well known, household finances generally deteriorated considerably during the recession. The percent of households reporting being worse off financially than the previous year rose sharply and the percent better off financially fell considerably. Altogether, this suggests that at least some of the steep decline in income expectations might simply be a reflection of more households than usual experiencing adverse shocks to their own finances.
To further investigate this explanation, I use the variation across households to identify the relationship between income expectations and selected household characteristics and experiences. The household characteristics included are age, education, and gender. To proxy for households' experiences, I use the unemployment rate in a respondent's state of residence, the change in respondent personal finances (just presented above), and the change in respondent home value. For this regression analysis, I pooled all household responses from January 2007 to April 2012. I also remove the average differences in income expectations from quarter to quarter and across states of residence.
Household Circumstances Only Partly Explain Lower Expectations
The last chart uses the estimated relationships to decompose the change in income expectations by households' experiences, households' characteristics, and an unexplained residual.
From 2007 to 2009, income expectations fell about 30 index points (the left bar), and almost two-thirds of the decline was accounted for by households' adverse experiences (the blue portion of the bar). Household characteristics played only a small role (the red portion), and one-third of the decline in income expectations was unexplained by the variables associated with households (the green portion).
The recovery in income expectations from 2009 to the first half of 2012 (the right bar) has mainly reflected modest improvements in economic experiences, whereas the unexplained improvement has been small. Notably, the unexplained drag on expectations in the recession has not been unwound. This pattern could imply a permanent downshift in income expectations. Alternatively, it might signal the potential for a bounce back in expectations.
In summary, the pessimism of households about their future income is deep and broad based. The large and persistent decline in income expectations in the aggregate data is evident among several different types of households. This analysis also shows that adverse experiences of households can account for half of the net decline in income expectations since 2007. Given the only modest improvement in household finances and the labor market seen in the aggregate, it is perhaps not surprising that income expectations remain downbeat. Moreover, the large, unexplained shock to income expectations might suggest a permanent change in households' views--a phenomenon that would continue to weigh against a recovery in consumer spending. Or the unwinding of this excess pessimism might provide an extra boost to spending as the economy picks up further. This article highlights some recent work on income expectations--an area of ongoing study.
1. The Michigan survey is a nationally representative monthly survey based on about 500 telephone interviews. Individuals are selected for the survey using random digit dial sampling (including a cell phone sample) and are interviewed twice, six months apart. See www.sca.isr.umich.edu for more information on the survey. Return to text
Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers.