| Sunday’s podcast in FX Compass will feature a chat with John Coscia, Director of Portfolio and Funding with City National Bank’s Treasury group. The focus will be on how the current fiscal and monetary programs interact with the banking system in ways many do not understand. It is a fascinating topic that affects the financial system worldwide.|
According to the Federal Reserve, the net worth for U.S. households, as of the end of 2020, rose to a record-setting $130.2 trillion. With historically low rates, elevated stock prices, strong growth in housing prices and the passage of another $1.9 trillion in fiscal stimulus, the backdrop for U.S. and global growth is unusually supportive, especially for economies just coming out of a recession.
One of the core drivers of consumer spending is the “wealth effect.” The theory, which was the basis of Franco Modigliani’s Nobel Prize in 1985, goes that increased wealth leads to more spending over time as households draw down their assets.
In an effort to measure the wealth effect, two assumptions are generally made. The first is that the amount spent per dollar of wealth is small due to the fact that most wealth is concentrated among the highest-income families who tend to spend gradually over time. Typically, this spend rate is assumed to be 4%, but there is some variability to this coefficient, as it increased before the Great Financial Crisis due to people drawing on home equity and fell after the crisis as people sought to rebuild their balance sheets. The second assumption is that the wealth effect is lagged, as people do not want to spend unless they think their wealth gains will be sustained.
Empirical evidence tells us that the wealth effect tends to fade during and immediately after recessions as the drop in value of assets erases earlier gains, weighing on spending. This effect was particularly acute after the Great Recession, when both stocks and home prices collapsed. Prior to this recession, the wealth effect was estimated to add 2% to the growth in consumer spending, but during the recession, the wealth effect went negative. A similar cycle was seen during the tech bubble in 2000, although the recovery was much shorter. It took five years for the wealth effect to recover back to normal after the tech bubble versus nearly seven years after the real estate bubble.
Today, the wealth effect tells a story that is the opposite of what it would normally tell during the current stage of the business cycle. Three quarters into the last expansion, the wealth effect was a net drag on growth, whereas three quarters into this expansion, the wealth effect is not only positive but also well above average, close to where it normally is in the boom phase of the business cycle.
Of course all of these calculations involve assumptions and estimates, but they do reinforce what numerous other financial indicators suggest. With interest rates still low and asset prices higher and only a small offset from higher bond yields, the U.S. economy, once reopened, should benefit from significant tailwinds. But it isn’t just the U.S. economy that will benefit—most of the world will too, as tailwinds are strong all around. The FTSE global stock index is up 16% from its pre-crisis high, and housing prices, as tracked by the Organization for Economic Co-operation and Development, are up 2% to 10% across 40 different countries.
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