The Consumer And The Fed: A Relationship Based On Trickery Or Understanding?

by: Daniel Moser

In an economic letter titled, The Effects of Wealth Bubbles on Consumption, by the Adrian Peralta-Alva, Senior Economist at the Federal Reserve of St. Louis, a study conducted by a few other economists regarding the relationship between wealth and consumption is reviewed. According to this analysis virtually all of the changes in consumption over the past two decades can be explained by changes in wealth.

The author introduces the permanent income hypothesis which posits that "households desire a smooth consumption pattern." The author goes on to argue based on this logic that "consumption should be weakly related to current income but strongly related to the discounted present value of the income that households expect to earn." Streams of earnings, which the author notes, "depend on households' stocks of human capital, and financial wealth". Accordingly, "the permanent income hypothesis suggests that the emergence and bursting of unanticipated asset price bubbles will cause movements in consumption through these channels." To help depict the existing relationship the author included two basic charts shown below:

Chart 1

Chart 2

The second chart provides an excellent demonstration of what the Federal Reserve is trying to accomplish with quantitative easing. In the mind of the Fed, if stock prices and home values appreciate the consumer will get back to the proverbial store and the economy will actually start a meaningful recovery thereby reducing unemployment. But what if consumers finally learned their lesson during this crisis?

The question that the author should be asking is "should a household consume predicated on the present value of their future earnings?" It was that very logic that helped many homeowners stretch well beyond their means. There are countless examples of homeowners refinancing their homes to fund new appliance purchases or even new additions to their home. Despite stagnant incomes, households confused asset appreciation with increases in earnings. If households had instead focused on current income to evaluate how much they should consume, then many of the challenges they are currently faced with would be non-existent. So the question should be…did the consumer learn anything?

If in fact the consumer did learn their lesson and implicitly switch to a household consumption model more closely aligned with reality i.e. current income, then the hypothesized positive impacts of quantitative easing must be called into question. As time goes on, the Federal Reserve is studying the impacts of quantitative easing and many of the FOMC members are increasingly questioning the impacts of additional monetary stimulus on the overall economy. If the psyche of the consumer has been altered, additional monetary stimulus won't likely help Main St. and thus, should not be enacted due to the fear of unintended consequences.

Thanks for reading.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.