UPDATING THE IMPACT: Post-recession monetary policy has explicitly targeted asset re-flation in hopes of the ultimate trickle down & around effect as the beneficiaries of that policy jumpstart aggregate demand via rising consumption and investment spending.
With the incremental tapering announced yesterday and as the committee moves towards a complete cessation of wealth effect policy targeting, we thought it worthwhile to highlight the magnitude of housing and financial asset price inflation over the TTM and the implied wealth effect impact.
Below we reprise a note we published last year, updating the numbers for the latest, 1Q14 household sector housing and equity asset values from the Feds Flow of Funds report. We largely focus the discussion around housing wealth due to the broader set of considerations, but the same conceptual framework holds for financial assets.
WEALTH EFFECT - WHAT IS IT: When home prices rise at a premium to inflation, real housing wealth increases. The wealth effect ‘theory’ posits that when real housing wealth increases, consumer spending permanently increases by some fraction of that wealth increase in every subsequent year - the same idea applies to financial assets. It’s the “some fraction” part of the theory that sits at the center of ongoing research and debate.
Consumers, on balance, don’t immediately convert 100% of a wealth increase into current consumption. Instead, in annuity like fashion, they tend to spread that ability for increased consumption out over their lifetime.
Economists attempt to quantify this phenomenon - how consumption changes following changes in housing wealth - by measuring “Marginal Propensity to Consume” – the term used to describe how much consumer spending increases for each additional dollar of housing/financial asset wealth. In general, studies examining the marginal propensity to consume show that consumer spending increases between 2 and 7 cents for each dollar of housing wealth increase.
Actual increases in housing wealth as well as expectations around future price appreciation are thought to be the lead factors driving consumption and spending decisions. The important, if obvious point, here is that even if home price appreciation is positive, if it’s less than what consumer were expecting (& basing spending decisions on) then the impact to go-forward consumption would be negative, and vice versa. Households would increase/decrease their savings rate to close the delta between expected and actual housing wealth changes.
KEY CONDITIONS: It makes intuitive sense that an increase in real wealth, be it from housing or financial asset appreciation, lends itself to increased consumption. However, a number of key, practical conditions must be satisfied for increased housing wealth to translate into higher consumer spending on non-housing related goods and services.
- Non-housing Assets: Rising home values don’t serve as direct means for increased consumption. Housing wealth increases need to displace other savings and investment for it free up cash flow to drive higher discretionary consumption. Put differently, an increase in housing wealth only drives increased consumption if households hold fewer non-housing assets than they would otherwise have held. Historically, real increases in housing wealth have been associated with a decrease in the personal savings rate. In effect, individuals let their home do their saving for them while diverting would-be savings into greater current consumption.
- Equity Extraction: Home price appreciation can help drive non-housing related consumption if it causes households to extract equity via increased borrowing, generally via cash-out refinancing’s (the technical term for this is Net Mortgage Equity Withdrawal, or MEW). Additionally, households can extract equity by simply moving to a cheaper residence with the dollar delta between the two homes representing the increased capacity for non-housing related consumption.
In short, if real housing wealth increases but households don’t decrease savings/other investment, increase home equity backed borrowing, or downsize to a cheaper residence, then that wealth increase will be largely ineffectual in driving higher consumption growth.
Net-Net, What Kind of Impact Will Increased Housing and Financial Wealth have on Consumer Spending and Consumption Growth?
The idea of the Wealth effect remains a working theory with the net impact to GDP beholden to a host of situational specific and idiosyncratic economic and behavioral/psychological factors.
Despite the inherent uncertainty, applying a few simplifying assumptions allows for a reasonable estimation of the net impact to consumption stemming from a real housing and equity wealth increase.
In the scenario analysis below we applied the range of historical estimates for Individual’s Marginal Propensity to Consume (MPC) against the actual increase in aggregate, gross housing market and corporate equity values from 2013 to 2014 (Fed Flow of Funds Data).
Across the range of MPC’s, on a nominal GDP base of $17.1T, the realized $2.3T increase in gross housing market value translates to 41-97 bps points of incremental growth while the $2.0T rise in equity values translates to 36-84 bps of incremental growth.
On the housing side, against the estimate of gross wealth effect impact, we applied a series of discounts to arrive at a net impact:
- Negative Equity discount: Is a rising home price really going to drive incremental spending for an individual going from very negative equity to less negative equity – particularly with wealth losses concentrated in the lower tiers where MPC’s are highest? As of year-end 2013, approximately 13% of all homes were underwater – implying that 87% of homeowner are subject to the wealth effect. We applied a 15% discount to the Gross Wealth Effect impact to account for negative housing equity in the analysis below.
- MEW Discount: Net Mortgage Equity Withdrawal peaked at ~$140B during the housing bubble and subsequently went negative into and after the great recession. Here, we take a conservative view and side with the preponderance of data that says the consumer still isn’t in a mood or position to re-lever. We applied a 10% discount for MEW with the expectation for a depressed impact versus historical precedent.
- Confidence/Psychological Discount: Expectations around wealth increases play an important part in marginal spending decisions. Similar behavioral dynamics tend to characterize positive and negative price/wealth inflections, but they tend to play out in converse – a phenomenon which is largely tied to expectations. Individual expectations around future price changes are generally biased by ‘State Dependence’ (ie. how you feel now) whereby recent price trends color expectations around future price changes. Applied to housing, as home prices rise/accelerate, consumers generally extrapolate forward similar levels of price appreciation. Conversely, coming out of a period of declining prices, expectations around future price changes are probably conservative with consumer needing to see sustained stability/appreciation to drive incremental spending. We applied a 5% discount for this dynamic in the scenario analysis below.
IMPLIED NET IMPACT: A quasi-conservative approach at quantifying the flow through impact from increased housing and equity wealth to consumer spending suggests we see a collective 80-130bps of incremental consumption growth over the NTM.
Its worth noting that the marginal propensity to consumer for wealthy households (ie. the one’s who own financial assets) is typically lower than that of middle and low income households.
Further, the distribution of still under water homeowners is concentrated in the lower price tiers – again, in the group where MPC’s are highest. Given these two realities, actual wealth effect spending is more likely than not to be below both historical precedent and the implied impact in the scenario analysis below.
Christian B. Drake