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The Uncertain Wealth Effect

Economic Trends


If stocks fall, will spending crash?

Only a few months ago, economists were speculating that a long-awaited pickup in savings by baby boomers had finally arrived. After falling for a dozen years, the personal savings rate began trending higher in 1995 and hit a four-year peak earlier this year.

Then, as part of its annual revisions of the national accounts, the government lowered the rate for each of the previous seven quarters--changing its trajectory in recent years from a steady rise to a continuing decline. The upshot is that the savings rate for 1997 is now on track to finish the year at less than 4% for the first time in 50 years.

What's more, economist John Hancock of Regional Financial Associates points out that the true rate may be even lower. That's because there is currently a sizable discrepancy between the government's measure of gross domestic product, which is dominated by consumer spending, and its higher measure of national income, which is dominated by household income. Assuming consumption is understated and/or household income is overstated, the savings rate may now be less than 3%.

Statistical problems aside, the falling savings rate suggests that the stock market boom has generated a powerful wealth effect that has buoyed consumer spending and economic growth. As Hancock notes, stocks are now the largest asset in household balance sheets, accounting for a third of net worth and surpassing the value of real estate holdings for the first time ever. With more and more households owning stock via mutual funds or savings plans, it's no surprise that many regard their new wealth as reason to spend more freely out of current income.

But the critical question is whether the depressed savings rate and the current wealth euphoria mean trouble ahead. Many economists don't think so. With savings so low and stock market gains harder to come by, they see a healthy slowdown in consumer spending developing--in line with a more sustainable pace of economic growth.

Even a market drop of 15%, notes Hancock, would leave prices above where they were at the start of the year. Given the pileup of capital gains in previous years, he doubts whether such a correction would panic investors and spark the kind of spending decline that might trigger a recession.

But others aren't so sure. Stephen S. Roach of Morgan Stanley Dean Witter worries about a reverse wealth effect that is "asymmetrical"--causing a consumption contraction far greater than the spending surge generated by the market boom. "No one really knows," he says, "how consumers would react to a serious market correction."BY GENE KORETZReturn to top

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Only in some services, a study says

Although policymakers and the financial markets worry that rises in labor compensation could trigger inflation, past research has often found a negligible impact. In a new study, David A. Brauer of the Federal Reserve Bank of New York reexamines the issue by looking at how pay increases in different sectors affect related product prices.

Brauer focuses on two classes of items in the consumer price index: labor-cost-sensitive goods, including cars, apparel, and home furnishings; and labor-cost-sensitive services, including restaurant meals, auto insurance, airfares, and personal services. These account for 19% and 23% of the CPI, respectively, with the rest of the index reflecting items less affected by labor costs (examples are fuel, groceries, utilities, housing, medical care, and tobacco).

Looking at the period from 1983 to mid-1997, Brauer found no evidence that changes in compensation in goods-producing industries precede changes in prices of labor-cost-sensitive goods. Presumably, competition from low-cost foreign or domestic rivals restrains prices.

In services, however, Brauer found that pickups in pay do result in more rapid inflation--both directly via the prices of labor-cost-sensitive services and indirectly as the cost of such services influences other components of the CPI. Adding these two effects together, he estimates that a one-percentage-point rise in the growth rate of hourly compensation in services raises overall inflation by about two-tenths of a percentage point within a year.

Such results seem to bode well for the current inflation outlook. Over the past two years, services compensation has shown no sign of accelerating from its 3% annual pace.BY GENE KORETZReturn to top

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