Monday, March 25, 2013

Is the wealth effect working?

The Fed has caused asset prices to increase in an effort to improve wealth. This increase should lead to the rebirth of consumer spending. This is what was the policy in place after the Tech decline. The Fed drove down interest rates to create a wealth effect; however, the result was a bubble in housing that may have pushed spending higher but then lead to the reverse effect post 2007. Are we making the same mistakes again?

 Researchers have found a weak effect between stock wealth and consumption and stronger effect with respect to housing wealth increases. The elasticity with respect to housing in down markets has been measured to be about .1 so a housing decline of 30+% should lead to a decline in consumer spending of about 3%. The sensitivity to up markets has been measured to be less and there has been less of a wealth effect since 2008. The may be associated with the greater uncertainty about wealth gains. Note that the VIXX volatility index has actually declined over this period. Nevertheless, given the lower sensitivity, there needs to be more of a wealth increase to get consumption higher. If the Fed tries to engineer this increase in wealth, we may be left with another bubble.

No comments: