Weighing The Wealth Effect

Is it just too hard to predict?

Fed Chairman Alan Greenspan has often worried that the increase in Americans' stock market wealth could cause them to overspend. In a June 17 speech to the Congressional Joint Economic Committee, he said that recent capital gains will "support outsized increases in consumption for many months into the future."

But a new study by two staffers of the Federal Reserve Bank of New York says there's no reliable correlation between stock market gains and future consumer spending. Economist Sydney Ludvigson and Senior Vice-President Charles Steindel conclude that on average, a lasting $1 increase in stock wealth leads to a 3 cents to 4 cents increase in annual consumption. But they say that this average is "a very shaky reed to lean on," because at various times the wealth effect has swung from 2 cents to almost 11 cents.

Ludvigson and Steindel also say it's impossible to predict how quickly the wealth effect--however big it is--will kick in. It can take years for consumer spending to reach a permanently higher level. "Forecasts of future consumption growth are not typically improved by taking changes in existing wealth into account," they conclude.

Greenspan's ruminations on the stock market seem to assume a more reliable correlation between wealth gains and spending. The New York Fed authors declined to discuss the policy implications of their paper. Says Steindel: "This is a statistical paper. We're not making a forecast of what's going to happen in the current environment."