Pent-up demand is spending by consumers and businesses that is postponed. It is a force that, once released, will help drive economic expansion.

Sources of Pent-Up Demand

There are a number of sources for pent-up demand. Wartime production controls can result in some goods not being produced and thus unavailable for purchase (e.g., new automobiles during World War II). Price and rent controls can create pent-up demand because they decrease the supply of goods subject to such controls. Deflationary expectations encourage consumers to hold off making purchases in anticipation of paying lower prices in the future.

The primary source of pent-up demand, though, is recession. Economic downturns temporarily alter demand for consumer durable goods and business equipment because disposable incomes and profits are reduced and increased uncertainty makes consumers and businesses more cautious. The purchases of consumer durables and business equipment can be postponed, but these products eventually wear out and require replacement.

Pent-Up Demand and the "Great Recession"

There is pent-up demand for automobiles, housing, and business equipment and machinery that has been built up over the past four years. Per capita disposable income in the fourth quarter of 2011, adjusted for inflation, was 2.2 percent below its level in the fourth quarter of 2007. Profits in the manufacturing sector, as measured by aggregate net income after taxes, fell from $136 billion in mid-2007 to a loss of $84 billion in the fourth quarter of 2008. Although profits rose after 2008, it wasn't until 2011 that manufacturing sector profits returned to more normal levels.

Figure 1 shows how the ranges of economic forecasts reported in Consensus Forecasts each May from 2005 through 2011 increased with the onset of the recession.[1] The enlarged ranges—differences between the high and low forecast of economic growth for the following year—in 2008 and 2009 reflect great uncertainty as to how the economy was expected to perform.

Figure 1 – Range of Consensus GDP Forecasts for the Following Year

Source(s): Consensus Forecasts

Pent-Up Demand for Consumer Durables

As shown in Table 1, spending on durable goods plummeted in 2008, especially when compared to total consumption spending.[2] It then rebounded sharply in the third quarter of 2009 and has outpaced total consumption spending in every quarter since the start of 2010 with the exception of the third quarter of 2011. The pattern of consumer spending on durable goods during the 2008-2009 recession—a sharp fall and then increase—is consistent with that of previous economic cycles.

Table 1 – Spending: Durable Goods vs. Total Consumption
(Quarterly percent change at annual rate)

Source(s): Bureau of Economic Analysis

Vehicle Sales

Despite the increase in durable goods spending, vehicle sales (automobiles and light trucks) are still well below a normal rate. Approximately 12.8 million vehicles were sold in 2011, a big improvement from the 10.4 million units sold in 2009, but still well below the annual rate of 16 million that many consider a "normal" annual rate. The average age of cars is rising as individuals hold onto their vehicles longer (an average of 11.1 years in 2011), a trend that predates the recession: in 1969, the average age of automobiles was just 5.1 years and by 1995 rose to 8.4 years.

This increase in vehicle age reflects in part the improved quality of automobiles. But given the rapidity with which sales fell after 2007, it is clear the recession had a major impact. From 2002 through 2007, vehicle sales averaged 16.6 million units annually. Over the four-year period of 2008 through 2011, sales averaged 12 million units. The annual difference of 4.7 million units, when multiplied fourfold, yields an estimated pent-up demand of 18.7 million units. If normal annual sales are only 16 million units rather than 16.6 million units, then the four-year difference yields an estimated pent-up demand of 16 million units.

In either case, it is clear that there is significant pent-up demand for automobiles. Even allowing for improved quality and longer vehicle life, sales should keep improving (assuming the economic recovery continues).

Housing Starts

There is also pent-up demand for housing, though it is of a lesser magnitude. In a "normal" year, approximately 1.5 million units would be added to the housing stock to replace an estimated 400,000 units lost annually by fire, dilapidation, etc., and to accommodate the formation of about 1.1 million new households. From 2008 through 2011, housing starts averaged just 663,000 per year. The annual difference between 1.5 million units and 663,000 summed over the period of 2008 through 2011 is equal to 3.3 million units.

Housing starts averaged 1.72 million over the 10-year period of 1998 through 2007, suggesting that overbuilding (one consequence of the housing bubble) added an extra 216,000 units annually—or 2.16 million units over the 10-year period. Subtracting this number from 3.3 million units means that the pent-up demand for housing is closer to 1.1 million units.

Given the current state of the sector, it may be difficult to see any pent-up demand. The housing sector is depressed, owing to the slowdown in new household formation as many young adults moved in with parents or friends. In addition, despite low mortgage rates, financing is harder to arrange and selling one's existing house can be difficult. Finally, there is an element of deflationary expectations that is curbing sales; some prospective homebuyers are hesitant to commit to a purchase because they fear prices will fall even further.

Nonetheless, pent-up demand exists and it is growing. In 1982, a year of deep recession, there was one housing start per 350 persons. In 2011, there was one housing start for every 727 persons.[3] A more robust rate of economic growth will convert notional or pent-up demand into an effective demand for housing.

Investment in Equipment and Machinery

Businesses can also have pent-up demand for investments they make. As profits fall and uncertainty increases, companies slow their replacement of existing equipment and reduce investments in new equipment and machinery. As replacement is delayed, the average age of equipment increases, creating pent-up demand for purchases since existing equipment eventually wears out and becomes technologically obsolete.

As shown in Figure 2, investment in equipment fell rapidly during the recession. It has since rebounded, aided by the ability to fully expense investments in equipment in 2010 and 2011 as well as by pent-up demand. Investment in equipment remains below its previous peak but is expected to continue increasing as the economy expands and as older equipment continues to be replaced.

Figure 2 – Investment in Industrial Equipment

Source(s): Bureau of Economic Analysis

Pent-Up Demand: Cause or Effect?

The release of pent-up demand is a driver of economic recovery. The pent-up demand for automobiles is significant while the need to replace business equipment helps explain the strong growth in investment. At the same time, the increased incomes and profits generated by a growing economy facilitate purchases of consumer durables such as automobiles and appliances, business equipment, and housing. The feedback effect of these purchases is to reinforce economic expansion, thereby creating a virtuous circle extending the economic expansion.

Footnotes

[1] The ranges of forecasts shown in Figure 1 were based on forecasts of GDP for the following year. The number of forecasters varied from 24 to 26 over this period.

[2] Durable goods are those which are expected to last for three years or more. Spending on durable goods has accounted for an average of 12.3 percent of total consumer spending since the start of 2000.

[3] Binyamin Appelbaum, “Signs of a Bottom in Housing,” New York Times, Economix, January 19, 2012, http://t.co/vMeFzRJQ.