Benchmark Revisions and the U.S. Personal Saving Rate. Leonard I. Nakamura and Tom Stark. Federal Reserve Bank of Philadelphia.

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1 Benchmark Revisions and the U.S. Personal Saving Rate Leonard I. Nakamura and Tom Stark Federal Reserve Bank of Philadelphia June 2006 JEL codes: E01 E21 C82 Keywords: Saving; Permanent Income; Real-time data The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System. We thank Dean Croushore, Mike Dotsey, and Todd Clark for ideas and advice as well as participants at the Econometric Society 2006 Winter Meetings. We would like to thank John Chew, Mike Conlow, Will Olney, and Daniel Tannenbaum for superb research assistance.

2 Benchmark Revisions and the U.S. Personal Saving Rate Leonard I. Nakamura and Tom Stark ABSTRACT According to the permanent income hypothesis, a low personal saving rate should predict rising future income (Campbell, 1987). However, the U.S. personal saving rate is initially poorly measured and has been repeatedly revised upward in benchmark revisions. We discuss the sources of these revisions and show they affect levels of the savings rate more than first differences. We use both conventional and real-time estimates of the personal saving rate in vector autoregressions to forecast real disposable income; using the level of the personal saving rate in real-time would have almost invariably made forecasts worse, but first differences of the personal saving rate are predictive. We also test the lay hypothesis that a low personal saving rate implies a low rate of real personal consumption growth in the future, and find no evidence of forecasting ability, either in conventional or real-time forecasts. Correspondence to: Leonard I. Nakamura, Research Department, Federal Reserve Bank of Philadelphia, 10 Independence Mall, Philadelphia, PA 19106, (office), (fax), leonard.nakamura@phil.frb.org ( ). Tom Stark, Research Department, Federal Reserve Bank of Philadelphia, 10 Independence Mall, Philadelphia, PA 19106, (office), (fax), tom.stark@phil.frb.org ( ). 1

3 Benchmark Revisions and the U.S. Personal Saving Rate I. Introduction If consumption obeys the permanent income hypothesis, then as Campbell (1987) has shown, a low personal saving rate implies that real labor income is expected to accelerate. On the other hand, over the past four decades, when the personal savings rate has first been published it was almost always too low, and it has been revised upwards over the course of benchmark revisions. We show that in real-time, the level of the personal savings rate is uninformative for forecasting real disposable income growth it is simply too noisy initially. 1 The first difference of the savings rate, however, has value in forecasting real income growth. There is also a persistent lay hypothesis that a low personal saving rate signals an overextended consumer and future consumption decline, a hypothesis that has been put forward in U.S. monetary policy discussions. 2 We show that the level of the personal saving rate has no forecasting power for personal consumption expenditure, either in latest vintage data or in real time. Economists have questioned how well personal saving is measured at least since Taubman (1968). Initially published estimates of the personal saving rate from 1965 Q3 to 1999 Q2 have been revised upward more than fifty percent, from 5.3 percent to 8.1 percent, as we document. Most of these revisions are due to the benchmark revisions that follow economic censuses, with large revisions decades after the initial estimate, in turn due to large upward 1 We forecast real disposable income growth rather than real labor income growth because of data availability. 2 For example, the minutes to the September 2004 U.S. Federal Open Market Committee meeting state, Members perceived several possible sources of downside risk to household spending. In particular, households might hold back on spending in an attempt to increase their saving, which had fallen to a very low level relative to income. 2

4 revisions to both disposable personal income and personal outlays. Nominal disposable personal income from 1965 Q3 to 1999 Q2 has been revised up 8.3 percent from initial publication. 3 Benchmark revisions substantially change the relative ranking of saving rates for individual quarters and five-year averages. For example, the early 1980s is now viewed as the period with the highest saving rates in the postwar period; yet when first published it was reported to have had the lowest saving rates since the Korean War. Revision does appear to bring us closer to the true state of affairs that economic agents confront. For tests of the permanent income hypothesis carried out by Campbell (1987) and Ireland (1995), revised data are preferable. But to test the practical value of an economic relationship for forecasting the n-step-ahead test based on real-time data should be preferred. In related work, Mankiw and Shapiro (1986) argued that GNP revisions are rational forecasts of final data, but they used only a very short time series. Aruoba (2005), using more data, argues that revisions are not well-behaved, even when benchmark revisions are omitted. However, these tests are not related to forecasting: rationality of estimates is not crucial to forecast value. In what follows, we briefly review our dataset and the process the U.S. Bureau of Economic Analysis (BEA) uses to revise national accounts data, and show that the major changes to the personal saving have occurred in benchmark revisions. We describe revisions to the 1979 personal saving rate and disposable income, as an example of the impact of the revisions. Finally, we use both conventional and real-time estimates of the personal saving rate to forecast real disposable income. We show that adding the level of the personal saving rate to univariate AR models in real-time almost invariably makes the real-time forecasts worse, but adding the first difference of the saving rate improves real-time forecasts. When we add cross-equation restrictions implied by the permanent income hypothesis, real-time forecasts are improved both in 3 Boskin (2000) has pointed out the large upward revisions of nominal national income that have occurred over time. 3

5 levels and first difference VARs, but the constrained VARs in levels generally do not improve on the univariate forecasts. The use of real-time data in this case provides us with information about the revision process that allows us both to avoid an empirical relationship that data limitations render invalid for forecasting purposes and to craft an alternative that rescues some of the valuable forecast information the personal saving rate contains. II. Real-Time Data And Revisions To The Personal Saving Rate The Federal Reserve Bank of Philadelphia maintains a real-time data set for macroeconomists that consists of vintage snapshots of data as they were reported in the middle of each quarter from 1965 Q3 to the present; it is documented in Croushore and Stark (2001) and on-line at Definitions and measurement difficulties. The personal saving rate is personal saving as a percentage of disposable (after-tax) personal income. Personal saving, in turn, is disposable personal income less personal outlays. Disposable personal income includes wages and salary income and benefits, proprietors and rental income, dividend and interest income, and transfer payments such as social security benefits, less contributions to social insurance and taxes. As such, it represents the income of households, nonprofits, and noncorporate businesses. Some of these items are easily measured, such as social insurance benefits and contributions, but other benefits and transfers are subject to measurement and conceptual problems. Wages and proprietors income are subject to underreporting in government records as a result of tax evasion. And rental income and proprietors income are net income measures that require quantification of depreciation and other expenses that are hard to define and measure well. Personal outlays are personal consumption expenditures (95 percent of personal outlays) plus transfers and nonmortgage interest payments. 4 4 Mortgage interest payments are netted out of rental income. 4

6 Capital gains on equity (other than from qualified equity stock options) and real estate are not included in personal income. A general rule of national income accounting is to ignore income from capital gains, whether realized or not. BEA has chosen to include realized capital gains from employee stock options in its measures of personal income. (These capital gains are subtracted from corporate profit, so there is no net impact upon gross domestic income), Maki and Palumbo (2001) argue that the decline in the saving rate in the 1990s can be largely attributed to a fall in the saving rate for the highest income quintile, whose wealth-to-income ratio rose at the same time, presumably as a result of capital gains. 5 Thus personal income may be understated to the extent that the value of equity holdings appears as (uncounted) capital gains rather than (counted) dividends and employee stock options, and to the extent that the rental return to property ownership omits the capital gains from rising house prices. 6 The data revision process. The BEA revises the national income accounts as follows. Data on a given quarter s economic activity are first published in an advance estimate, late in the first month of the next quarter. 7 The data available at this time is recorded in the Philadelphia Fed s real-time data set as the vintage of that quarter. The revised estimate is published in the second month of a quarter followed a month later by a final estimate. These data are then generally left unchanged until the following summer, when the latest three years of national account data are revised. 8 A set of initial estimates thus undergoes three summer revisions. Thereafter, the estimates are only changed in what are called benchmark revisions, which now 5 Real capital gains, measured by the increase in stock market value of domestic corporations, averaged 10.4 percent of real disposable income from 1984 to 2004, and only 1.9 percent from 1954 to Rental income, including implied income from owner-occupied housing, in 2004 was $166 billion. This is a 1.2 percent nominal return on net equity of housing (for households, nonprofits, and nonfarm, noncorporate businesses) of $13.7 trillion from the Federal Reserve s flow of funds data. Over the entire period from 1965 to 2004, according to latest vintage information, the average nominal return was 1.5 percent. By comparison, for the same period. the return to the 12-month constant-maturity U.S. Treasury bill averaged 6.6 percent. 7 Until 1985, the BEA also published a flash GDP estimate 15 days before the end of a quarter, but this estimate only included aggregate nominal and real GDP, without any underlying detail (although some detail was circulated internally within the government), and did not include the personal saving rate. 8 One change in the routine has been that wages and salaries, since 2002 Q3, are revised again 3 months after the final estimate. 5

7 occur every four years. Benchmark revisions provide the opportunity for BEA to make discretionary choices in defining the items it considers to be part of personal income; in addition more complete data from economic censuses is included at this time. The personal saving rate from 1965 Q3 to 1999 Q2 was 5.3 percent if averaged over the rate first observed in the advance estimates (Figure 1); by the 2005Q3 vintage it averaged 8.1 percent. Thus the personal saving rate over time has been revised systematically upward. The upward revisions occur in benchmark revisions. As Figure 2 shows, revisions that occur between the advance estimate and the last vintage before any benchmark revision have been relatively unbiased and small, with the mean rise 0.08 percentage point and a mean squared revision of 1.11 percentage points. 9 By contrast, the revisions from advance estimates to the latest vintage (the data published in 2005 Q3) have a mean of 2.44 percentage points and a mean squared revision of 9.52 percentage points (Figure 3). The benchmark revisions thus account for very nearly all of the bias and the bulk of the mean squared revision. The revisions in the first three years after the data are first published are primarily from regular sources whose availability is delayed. Systematic biases related to these data can be estimated and eliminated, and BEA apparently has done so. Benchmark revisions, on the other hand, incorporate two basic types of changes: statistical changes, based on newly available data, and definitional changes. Statistical changes include data from censuses, such as the economic census or the population census, and other sources of data that become available with a long lag or irregularly, such as IRS random audit data. Definitional changes include changes in data recognition (such as reclassification of government pension contributions as personal income) and changes in concept (such as including software as investment or introducing chain-weighted prices). 9 This figure and accompanying data omit the advance estimates that occur just before a benchmark revision, and thus had no opportunity to change. We also excluded the last advance estimate, for 2005 Q2, for the same reason from both this and the next figure. 6

8 These steady upward shifts have applied to all periods. The data begin in 1965 Q3, and they are averaged into five-year periods (Table 1). 10 Of the 26 changes that these groups underwent in benchmark revisions, 16 were positive and greater than 0.5 percentage point. Another view of the vintage data is presented in figures 4a 4c, which show nine vintages in which the most recent saving rates are well below the average. Why are saving rate revisions biased upward? Two factors drive revisions: income is harder to measure than expenditures and economic evolution creates new sources of income. Income is harder to measure than final expenditure, because it must be collected from more units. The vast bulk of gross domestic product measured from the expenditure side is final sales of domestic purchasers. Final sales data purchases by consumers, businesses, and governments do not require information about the entire production chain, only the final point of sale. By contrast, to obtain gross domestic income we need data from each industry on labor and capital income. Retailers, for example, account for nearly one-third of final product, but only about onefifteenth of labor income. As income is costlier to collect, more of it escapes counting, particularly initially. Income-side data are aggregated to gross domestic income (GDI), conceptually the same as GDP, but in practice differing by between 2.3 percent and -1.8 percent; GDP minus GDI is called the statistical discrepancy. Generally speaking, the statistical discrepancy is positive since 1965 Q3 it has averaged of 0.7 percent, with 131 of 160 observations positive suggesting that typically income is undercounted. The fact that GDP and not GDI is used as the primary yardstick expresses BEA s judgment sense that it is the more precisely measured of the two aggregates. Upward revisions to disposable personal income income have been very large. Disposable personal income has been revised as much as 14.8 percent; on average, from 1965 Q3 to 1999 Q2, the revision has been 8.4 percent (Figure 5). Over the same period, nominal GDP 10 Complete data back to 1947 is occasionally not available until two or three quarters after a benchmark revision. 7

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10 40 Figure 2 Histogram of Revisions to the Personal Savings Rate Last-Before-Benchmark minus Advance Estimates Mean = 0.08 Std Dev = 1.06 MSE = 1.11 N = Count Revision (pct points) 38

11 Figure 3 Histogram of Revisions to the Personal Savings Rate Latest-Available Minus Advance Estimates Mean = 2.44 Std Dev = 1.88 MSE = 9.52 N = 160 Count Revision (Pct points) 39

12 Figure 4a Recent Saving Rates are Often Below Average : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : :04 80Q1Vintage 83Q3Vintage 87Q1Vintage

13 1994: : : : : : : : Figure 4b: Recent Saving Rates are Often Below Average 1970: : : : : : : : : : : : : : :04 88Q3Vintage 94Q2Vintage 97Q4Vintage : : : : : : : : :01

14 Figure 4c Recent Saving Rates are Often Below Average : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : :02 98Q3Vintage 01Q2Vintage 05Q4Vintage

15 2001: : : : : % 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% Figure 5 Revisions to Nominal Income and Output 1975: : : : : : : : : : : : : : : : : : :01 Disposable Personal Income Personal Outlays Nominal GNP/GDP : : : : : : : :04 Percent

16 0.0 Figure 6. Sum of Coefficients on the Saving Rate Sample Endpoint Notes. The figure plots the sum of coefficients on the saving rate from the VAR equation for real disposable personal income growth. The saving rate is expressed in percentage points. Income growth is expressed in annualized percentage points. Lag length was chosen by the SIC. All estimation begins with the observation for 1959Q1 and adds one additional real-time observation per quarter. The horizontal axis gives the sample endpoint. 44