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ESSAYS ON ISSUES AUGUST 1995 NUMBER 96 THE FEDERAL RESERVE BANK OF CHICAGO Chicago Fed Letter Auto outlook: Is the engine idling or stalling? On June 2, the Federal Reserve Bank of Chicago held its second annual Auto Outlook Symposium. This year’s program reassessed the health of the auto expansion. The recent sluggishness of auto sales dom inated the program and led to discussions of short-term and long-term influ ences on sales. Expectations persist ed of a rebound in sales from cur rent weak levels, and the general tone of the m eeting was cautiously optimistic. With car sales particularly slow even after a boost in incentives, some symposium participants expressed concern that the auto expansion is not simply idling, but has stalled. This Fed Letter reviews the discussions at the symposium and recent devel opm ents in the m otor vehicle indus try. Analysis suggests that several factors account for the sluggishness in the auto m arket over the last four months. These include rising inter est rates, the shift to used cars, and special one-time disruptions such as delayed income tax refunds. The question for the industry over the next year is how vehicle sales will be affected by the interplay between factors constraining sales and factors that should boost sales. Sales have been disappointing Vehicle sales since the end of 1994 have been disappointing by almost any measure. On a seasonally adjust ed annualized basis, sales through the first five m onths averaged an anemic 14.7 million units, down 700,000 units from 1994:Q4, and down 1 million units from the first five m onths of 1994. In April, sales hit a near-recessionary annualized rate of 13.9 million units, triggering widespread concern that sales had not just temporarily declined, but may actually be on a downward trend leading the economy into a reces sion. The primary source of the recent weakness is in passenger cars, where the seasonally adjusted annual ized sales rate for the first five m onths of this year was 8.6 million units com pared with 9.0 million in 1994:Q4. Moreover, despite aggres sive incentives, passenger car sales were down 6% com pared with the first five m onths of 1994. Luxury car sales declined m ore than 15% through the first five months. Small car sales were down m ore than 20%, with some models falling m ore than 25%. Indeed, the only bright spots in passenger cars were a few models such as the Chevrolet Lumina, or m ore recently, cars with high rebates such as the Dodge Neon, Ford Tau rus, and Toyota Camry. Although light truck sales have weak ened from fourth-quarter levels, they have held up better than passenger car sales. The seasonal ly adjusted annualized sales rate for light trucks was approxi mately 5.8 million units for the first five months. This pace was down from the blister ing 6.5 million units in the fourth quarter, but com parable as a whole to 1994. One continu ing area of strength is the sports/utility mar ket; the revamped Ford Explorer and Chevy Blazer have been sell ing extremely well, partly at the expense of Chrysler’sjeep Grand Cherokee. Total vehicle sales for the year to date are well below the expectations of most industry observers. For exam ple, the Big Three forecast of 1995 light vehicle sales at the beginning of this year ranged from 15.4 million to 16.1 million units. Even the most cautious forecast of 15.4 million units, made by participants at last year’s auto symposium, now appears m uch too optimistic. Not surprising ly, given sales to date, this year’s sym posium participants reduced their forecasts substantially for 1995 and 1996. The consensus forecast for 1995 is now 14.9 million light vehi cles, with sales expected to hold steady in 1996 (see figure 1). Explaining the slippage As vehicle sales have slumped more than expected, industry participants and observers have struggled to ex plain the weakness. It seems espe cially odd since most economic indi cators—especially income growth— have rem ained generally favorable. Note: Dashed line indicates consensus forecast. The shaded area indicates the range of forecasts. Source: Bureau of Economic Analysis, electronic database, 1995, and symposium participants. Declines in total employm ent over the last few m onths may be the first hint that macroeconom ic conditions have deteriorated and are hindering vehicle sales. Yet evidence of sub stantial economic sluggishness is spotty, and the evidence from the national economy seems to confirm a soft landing. The key question in the current situ ation is why sales are running 500,000 or m ore units below the seemingly reasonable forecast of 15 million to 15.5 million units, espe cially given the relative health of the economy. Participants noted many factors that account for this drop-off in sales. Special one-time disruptions that had an impact included higher tax payments, delayed refunds, and reduced fleet sales. Tax payments in April were up $20 billion from yearago levels, possibly causing a substan tial drag on consum er spending. W hen the IRS fell behind in issuing tax refunds, many consumers de layed vehicle purchases until they had the refund in hand to make a down payment. Additionally, fleet sales have declined since 1994:Q4, especially in April 1995, when both fleet and total sales fell dramatically. This reduction in fleet sales (approx imately 35,000 vehicles) from expect ed levels was caused in large measure by a concerted effort of m anufactur ers to shift sales away from April until later in the year. In the search for m ore fundam ental explanations for the sluggishness, attention has also shifted to the im pact of higher interest rates. Auto loan interest rates have increased 200 basis points since the beginning of the fourth quarter and have re m ained at these levels. These rates have increased far more rapidly than rates on instrum ents of comparable maturities. For example, rates of fered by auto finance companies have increased at twice the pace of the three-year Treasury note rate. After declining during m uch of 1994, the spread between the interest rates on auto loans and on the three-year Treasury note has increased by over 2 percentage points since the end of the year (see figure 2). ing the same period. In other words, total vehicle sales (new and 8 --------------------------------------------------------------------------------------used) were flat from the fourth quarter sales pace—not down, as new vehicles sales alone would suggest. The shift toward used vehicles may have also been accelerated by the surge in the num ber of higher-quality used vehicles entering __I....... . ■■ ■ I............ I.............1........ .. I........... I........ the m arket from lease program s in the fourth quarter. These vehicles may be prom pting buyers to move upstream Higher interest rates have had a sig nificant im pact on the affordability in vehicle models. For instance, of vehicles. For example, the average recent surveys suggest that used mid monthly payment for a new vehicle size cars are close substitutes for new has increased by approximately $40 com pact vehicles. Similarly, highover the past year, an increase of quality used large or luxury cars are 14%. Most of this increase stems becom ing a substitute for new mid from the rise in interest rates. size cars. One challenge for the in Monthly payments are currently at dustry will be the continuing inter almost 25% of per capita disposable play between new vehicle and income, up from less than 23% at the high-quality used vehicle sales over beginning of the year and to a level the next few years, as the increasing that has not been reached since the num ber of leased cars reach the used mid-1980s. As several participants vehicle market. pointed out, new vehicle prices have increased at a pace consistent with Beyond the near term prices in the economy as a whole, a Even accounting for the im pact of m arked difference from past expan higher auto loan rates and the drag sions (see figure 3). from higher tax payments, sales in In addition, the increase in m onthly the industry rem ain subpar compayments may be the reason for the continu ing shift toward used vehicles. Used vehicle purchases have been increasing on both an expenditure and a volume basis since 1988. On a seasonally adjusted annualized basis, used vehicle sales surged to almost 17 million units in the first quarter, up from 16.5 million in the fourth quarter. This matches virtually onefor-one the fall-off in new vehicle sales dur 2. Interest rate spread percent A u to lo a n s v e rs u s th re e -y e a r T re a s u ry n o te s 0 ------------------------------------------------------------------------------------------------------------1990 ’91 ’92 ’93 ’94 ’95 Source: Federal Reserve Board, electronic database, 1995. Source: U.S. Bureau of Labor Statistics, "Consumer Price Index," electronic database, 1995. Source: Bureau of Economic Analysis. pared with past expansions. Vehicle sales below 15 million units seem inconsistent with incom e growth and with most projections of pentup dem and since the expansion began in 1991. Consequently, one m ust look beyond short-term influ ences to explain the current sales sluggishness. O ne issue discussed at the confer ence was the view that vehicles were “oversold” in the late 1980s, con straining sales in the current expan sion. Assuming a trend sales growth rate of approxim ately 0.5%, pur chases during the expansion of the 1980s were alm ost 8 million units above trend. They were also be tween 1 m illion and 1.5 million units above the projected level of pent-up dem and during the early 1980s. The overselling of autos through aggressive incentives is also supported by expenditure data for the industry. Auto expenditures as a percentage of total consum er ex penditures were extrem ely strong in the late 1980s.1 Not surprisingly, auto expenditures in the early 1990s have been below expected levels (see figure 4). Im portant changes have also been occurring in the m arket for vehicles. The propensity to purchase new vehicles declined dramatically over the last twenty years. In the early 1970s the ratio of new vehicle pur chases per household was 18.5%; in the early 1990s it was about 14%. There was a similar reduction in the num ber of vehicles pur chased annually by people over the age of 18. Part of this change in behavior is due to the lengthening of the useful life of vehicles. The vehicle scrappage rate has declined over the last decade, espe cially am ong middleaged vehicles, six to eight years old. Prod uct quality improve m ents over the last few years should further lower the scrappage rate and, therefore, re duce vehicle purchases. The most controversial issue raised at the conference was vehicle afford ability. By standard measures such as num ber of weeks of family in come needed to buy a vehicle, af fordability appears to have deterio rated substantially over the last twenty years. However, some observ ers question the accuracy of vehicle price measures as com puted by gov ernm ent statistical agencies. Indus try measures suggest a m ore favor able relationship between vehicle prices and incom e levels. Bounce-back? Yes, but limited The auto industry has already begun to deal with many of the factors caus ing sluggish vehicle sales. To counter the decline in affordability, the industry has begun to im plem ent discount financing terms and in creased rebates. These should help lower the relative price of new vehi cles com pared with used vehicles. For example, an increase in rebates of $500 per vehicle would reduce monthly payments to the level of mid-1994. A rebate of $1,050 would bring payments back to the level of the first quarter of last year. Al though rebates of this size are not likely in the near term, discounts are likely and will represent an im por tant offset for the consum er.2 Many challenges on the horizon will continue to affect the auto industry. These include extended durability of autos, continued pressure from new vehicle substitutes, and pricing and affordability concerns. —William Strauss and Paul Ballew TBesides the impact of buying ahead through aggressive incentives, it is also important to note that the expansion began with a substantial tax increase. The resulting drag on consumer spend ing appeared significant in the early stages of the expansion, and should be incorporated into the analysis of the behavior of the vehicle expansion. 2Typically, incentives provide only a temporary boost to sales in the industry, and in some periods involve “buying” future sales today. As discussed above, the current pickup in incentives may not reflect this trend because incentives may be offsetting substantial increases in auto loan rates and the increasing acceptance of used cars as an alternative to new vehicles. Consequently, some improve ment in vehicle sales is expected. How ever, the gains will likely be modest. Michael H. Moskow, President', William C. Hunter, Senior Vice President and Director of Research; David R. Allardice, Vice President, regional programs; Douglas Evanoff, Assistant Vice President, financial studies; Charles Evans and Kenneth Kuttner, Assistant Vice Presidents, macroeconomic policy research; Daniel Sullivan, Assistant Vice President, microeconomic policy research; Anne Weaver, Manager, administration; Janice Weiss, Editor. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois, 60690-0834, (312) 322-5111. ISSN 0895-0164 Midwest m anufacturing output flattened out in recent m onths after weaken ing significantly in the first quarter of 1995, according to the Midwest M anu facturing Index. Much of the weakening in recent m onths was concentrated in durable goods industries, including transportation equipm ent and fabri cated metals. Retail sales and housing activity gained greater strength around the country in May and June. This has bolstered retailer and wholesaler confidence with inventory positions as well as District m anufacturers’ production plans for the latter half of the year. Sources: The Midwest Manufacturing Index (MMI) is a composite index of 15 industries, based on monthly hours worked and kilowatt hours. IP rep resents the Federal Reserve Board industrial pro duction index for the U.S. manufacturing sector. Autos and light trucks are measured in annualized units, using seasonal adjustments developed by the Board. The purchasing managers’ survey data for the Midwest are weighted averages of the sea sonally adjusted production components from the Chicago, Detroit, and Milwaukee Purchasing Man agers’ Association surveys, with assistance from Bishop Associates, Comerica, and the University of Wisconsin-Milwaukee. IU9-ZZS (Sfg) P£80-06909 siouini ‘oSediijo h£8 xog O d OOV3IH3 io ip q J31U33 uopnmjojuj oijqnj 3A^aS3H TVd3(I33 p a j ( X o P D iiy y )
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