Ignore The Wealth Effect At Your Peril

Desmond Lachman profile picture
Desmond Lachman
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Summary

  • The recent unusually large swing in household wealth is not getting the attention it deserves as another recession risk.
  • According to the St. Louis Federal Reserve, largely as a result of surging equity and home prices, household wealth increased from $116 trillion at the end of 2019 to $149 trillion at the end of 2021.
  • Since the start of this year, both equity and bond prices have declined by 20 percent while exotic markets like those of cryptocurrency have declined by some 70 percent.

businessman with money in his pocket and a poor worker with an empty pocket. The concept of income inequality of the population. Social stratification

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Among the more striking consequences of the Federal Reserve’s shift to a more hawkish monetary policy stance has been the swing in wealth creation from strong household wealth creation last year to rapid household wealth destruction this year. Yet despite past evidence that sustained changes in wealth do lead to changes in aggregate spending, the recent unusually large swing in household wealth is not getting the attention it deserves as another recession risk.

In early 2020, in response to the COVID-induced recession, the Fed resorted to an ultra-easy monetary policy stance. That stance involved both the reduction in its policy interest rate to its zero bound and to an aggressive round of bound US Treasury and mortgage-backed securities buying in the amount of more than $4 trillion. Those policies fueled the strongest stock market rally in the post-war period, as well as an unusually strong surge in home prices.

According to the St. Louis Federal Reserve, largely as a result of surging equity and home prices, household wealth increased from $116 trillion at the end of 2019 to $149 trillion at the end of 2021. This implies that over a two-year period, household wealth increased by some $33 trillion, or over 150 percent of GDP.

Fast-forward to 2022, and we get an entirely different picture as a result of the Fed’s start of an interest rate hiking cycle and a move from one of flooding the market with liquidity to one of withdrawing liquidity at an increasing pace. In the same way as the Fed’s bond buying last year increased market liquidity, the Fed is now withdrawing market liquidity by not rolling over its maturing bond holdings.

Since the start of this year, both equity and bond prices have declined by 20 percent, while exotic markets like those of cryptocurrency have declined by some 70 percent. Meanwhile, as a result of a doubling in mortgage rates from 3 percent at the start of the year to around 6 percent at present, Goldman Sachs is anticipating an early end to the period of rapid home price increases.

If sustained, the large decline in financial market prices to date this year, coupled with a prospective leveling off in home prices, could mean that some $15 trillion, or 70 percent of GDP, in household wealth will have evaporated in 2022. This amount is a little less than the $18 trillion increase in household wealth created in 2021. This means that the swing from wealth creation last year to wealth destruction this year will have amounted to around 150 percent of GDP.

In the past, the Federal Reserve has estimated that a sustained $1 loss in wealth leads to a three- to five-cent decline in aggregate spending. Even on the basis of the lower bound of those estimates, it would seem that the wealth effect could cause a swing in aggregate demand of around 4.5 percentage points of GDP between last year and this year.

Such a wealth-induced swing in aggregate demand could be sufficient to push a vulnerable US economy into recession. Consumer demand already is being affected adversely by high inflation, the housing market is crumbling as a result of high mortgage rates, and exports are being constrained by a strong dollar.

The prospect of a recession is particularly troubling in that it could lead to another leg down in the stock market. That, in turn, could further constrain aggregate demand through the wealth effect, which would push the economy further into recession.

All of this would suggest that the Fed might wish to revisit its current policy shift towards a more rapid pace of interest rate hikes and aggressive quantitative tightening. Those policies might be the last thing that the country needs at a time when its financial markets are in disarray and when its economy is headed towards a recession.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

This article was written by

Desmond Lachman profile picture
348 Followers
Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.

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