This is important because the Fed's monetary policy, including zero interest rates and quantitative easing, is reliant on the wealth effect to drive growth in demand.
Did this reliance ever make sense in anything other than an economic model?
There is no reason to believe that the wealthy dramatically increase or decrease their spending because of the level of interest rates rather than base their spending on what they earn as income each year.
If your humble blogger had to guess why economists believe in the wealth effect it is that they confuse correlation with causation.
Specifically, they saw consumption pick up over the last 30 years as both stock and house prices increased and said "aha, there must be a wealth effect as an increase in wealth is correlated with higher consumption".
In reality, what was really happening is that Wall Street became quite proficient at letting Main Street tap the equity in their houses and Main Street needed to tap this equity because growth in income was insufficient to support the lifestyle they had from previous years.
Federal Reserve officials have touted the ‘wealth effect’ from higher stock prices and rising home values as a key way in which monetary policy boosts consumer spending and economic activity.
But according to the results of a recent survey from the Royal Bank of Canada, that ethereal feeling of being richer on paper is no substitute for cold, hard cash.
Here’s how Fed Chairman Ben Bernanke explained the benefits of rising asset prices to the real economy during a press conference in September.
The tools we have involve affecting financial asset prices and those are the tools of monetary policy. There are a number of different channels – mortgage rates, I mentioned corporate bond rates, but also prices of various assets, like for example the prices of homes.
To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. So house prices is one vehicle....
The issue here is whether or not improving asset prices generally will make people more willing to spend.
One of the main concerns that firms have is there is not enough demand, there’s not enough people coming and demanding their products. If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand.....
RBC survey’s findings, explained by the bank’s chief U.S. economist, Tom Porcelli, in a research note:
That wages and the jobs backdrop matter for consumption is not only borne out in the hard data, but this also came through loud and clear in our June consumer survey.
When asked about what would embolden them to increase spending, nearly half of respondents noted wage increases while about 1/5 said a better job backdrop. So 65% of consumers think employment dynamics are what matter most. Contrary to popular belief, there was little “wealth effect” from stocks and housing apparent here.
The bad news: U.S. wages have been stagnant for quite a while.