The Federal Reserve Bank of Dallas in a recent report noted that several factors affect consumer spending: “Higher incomes and household wealth boost spending. Higher, real (inflation-adjusted) interest rates—which encourage consumers to save—reduce current spending.” (emphasis added).
I emphasized “and household wealth” for a reason. Many of the Fed’s recent monetary policy decisions, including quantitative easing and zero interest rates, were driven by a belief in the so-called wealth effect.
It is a notion, as noted before, that is very likely wrong.
Before I explain why this is much more likely a case of correlation than causation, a quick definition and background: The wealth effect is an economic theory that applies to both consumers and corporations. On the consumer side, it’s the idea that rising asset prices — especially for housing — boost consumer confidence, which in turn leads to an increase in retail spending. On the corporate side, that same improvement in sentiment leads to more capital expenditure and increased hiring. Once in motion, this virtuous cycle of higher prices leads to greater economic activity, more profits and still more positive sentiment. Repeat until recession or crisis interrupts.
The rule of thumb has been that for every $1 increase in a household’s equity wealth, spending increased 2 cents to 4 cents. For residential real estate, the increase is even greater: Consumer spending increases 9 cents to 15 cents (depending upon the study you use) for every dollar of gain.
The correlation is there; the problem is the lack of causation.
What these observations attempt to capture is the relationship between increased spending and rising asset prices. Only it confuses which causes which. Indeed, the longstanding economic theory has the historical relationship exactly backward: more spending (and profits) cause higher asset prices and improved sentiment, not the other way around.