Economists know that consumers spend more when their wealth increases, even if their income stays the same. However, if wealth decreases, the reverse happens.
The concept, known as the wealth effect, has driven the economy for more than a decade as savers’ 401(k) and other retirement accounts have grown year on year. At the same time, real estate values have also increased. Of course, most of the time these gains are just paper profits, unless you sell your house or take money out of your wallets.
Nevertheless, there is a behavioral element to this concept. People tend to spend more when stocks and house prices continue to rise, as they feel wealthier and become more optimistic. This is one of the reasons why consumer spending in the United States continues to remain robust – until recently.
The Federal Reserve Bank, in its past efforts to control inflation, has focused on suppressing the supply of credit in financial markets. They did this by raising interest rates and slowing bond purchases. However, this time around the Fed is also targeting the demand side of the economic equation. In this case, reducing demand would require reversing some of the wealth accumulated over the past ten years or more.
During the COVID-19 pandemic, stock portfolios and house prices have soared, thanks to the huge government monetary and fiscal stimulus that has taken place. The highest-earning people in the United States, who were working from home, splurged on home renovations, new cars, durable goods and all kinds of electronics. Billions of dollars in stimulus checks and unemployment benefits inflated consumer spending for those earning less.
As a result, all income groups have increased their spending at much faster rates than before the pandemic. The most recent government retail sales survey for April 2022 indicated that retail sales outpaced inflation for a fourth consecutive month. And as inflation climbs, high earners, who already make up a large share of overall consumption, seem willing to keep spending, at least for now.
These retail sales data don’t tell the whole story. Low- and even middle-income households are already reducing their spending. Demand decreases because the wealth effect seems to work in the opposite direction. According to a survey by brokerage firm Jeffries conducted in April 2022, nearly 60% of US consumers said they have reduced the number of items they typically buy. In each category, low- and middle-income consumers reduced significantly more than those in high-income groups.
Additionally, the National Retail Federation identified that 47% of consumers surveyed last month (April 2022) were also switching to cheaper products and alternatives. I have already highlighted this trend in previous columns. Consumers are reducing their meat consumption or choosing cheaper alternatives such as chicken, pork or fish. Private label supermarket sales are also booming.
But inflation is not the only variable that impacts consumers. Interest rates also play their role. Mortgage rates are the most obvious victims of a rising interest rate environment. Borrowing costs have jumped for 30-year mortgages, from below 3% last year to 5.25% today. April 2022 new home sales fell 16.6% from March and well below forecasts, the slowest pace since April 2020. Existing home sales have also fallen over the past three months. according to the National Association of Realtors.
Auto leases and loans and credit cards are also big areas where higher rates hit the consumer. Most credit cards and auto loans are charged at the prime rate, which in turn is closely tied to the federal funds rate. Consumers can expect these rates to rise, as the Federal Reserve plans to raise the federal funds rate at least twice more in the next two months.
The big question for most economists is when the combination of higher inflation, falling stock markets and a possible slowdown in the housing market will begin to reverse the wealth effect at levels highest income.
So far this year, many investors have suffered a 20-30% decline in their portfolios and retirement savings. People already have to rethink their retirement date accordingly. Inflation and supply shortages are holding back renovation and housing plans, although higher interest rates are expected to soon push house prices down. As a result, many Americans are starting to feel less affluent than they were a year ago.
The Fed is counting on all of the above to shift the psychology of consumers from spending like drunken sailors to something a little more subdued (but not enough to make them swear off completely). Tinkering with the wealth effect can have unpredictable reactions. How far is too far when trying to reduce demand? It’s a fine line, and the Fed’s tools to accomplish this feat are far from perfect. If they are wrong, the economy will likely suffer. Hope they do well.