Commentary: How Real Is The "Wealth Effect"?

A simmering debate within the Federal Reserve about the importance of the "wealth effect" could have a big impact on what the Fed does about interest rates in the months ahead. On one side is Chairman Alan Greenspan, who believes that the surging stock market overheated the economy by inducing consumers to spend newfound paper wealth. On the other side are wealth-effect skeptics, including William J. McDonough, president of the Federal Reserve Bank of New York. They believe that what really matters for spending is the "income effect": low unemployment and rising pay.

The recent cooling on Wall Street has brought their disagreement closer to the surface. Greenspan and fellow believers in the wealth effect are gaining confidence that a slowdown in the stock market will make it easier for the Fed to rein in the economy without severe increases in interest rates. But McDonough and others may be more likely to push for big rate rises even if the market remains well off its earlier high. "A fall in share prices is not the same as a slowdown in demand," says Sanwa Bank Ltd. economist Takanobu Igarashi in explaining the reasoning of the McDonough camp.

SPENDING MOOD. Wealth-effect skeptics have a point. And they gained some ammunition on May 30 from news that consumer confidence jumped sharply in May--despite a bad month for the stock market. That indicated that people can be in a spending mood even when Wall Street is in the pits. "With unemployment at a 30-year lowvolatile financial markets are not expected to have a significant impact on consumers' spirits," says Conference Board Director Lynn Franco.

The intellectual underpinning for wealth-effect skeptics is a paper written last year by New York Fed staffers Sydney Ludvigson and Charles Steindel. While not denying that rising stock prices can boost consumption, economist Ludvigson and Senior Vice-President Steindel argue that the correlation is weak. "Forecasts of future consumption growth are not typically improved by taking changes in existing wealth into account," they wrote.

What's important, the two Fed researchers argue, is whether investors perceive a shift in stock prices as temporary or permanent. If a market move is seen as transitory, it's unlikely to have much impact on consumption. Case in point: Despite widespread expectations that the 1987 stock market crash would hurt consumption and choke off the economy, nothing of the sort happened.

Associates say New York Fed President McDonough's skepticism about the potency of the wealth effect is one reason he was more cautious than some colleagues about raising rates last fall, when stocks were soaring and the economic outlook was uncertain. But since then, the economy has taken off and unemployment has fallen. And McDonough has sounded tougher, even as stocks stalled. "There is no question that the U.S. economy is beginning to exhibit signs of imbalance and strain," he said in a speech on May 3.

SECRET FEAR. McDonough is not alone in his concern about the stock market's role in the Fed's monetary deliberations. Some of his fellow central bankers at the Fed's regional branches have privately voiced dismay at Greenspan's seeming obsession with Wall Street. Their secret fear: The Fed will end up with the blame if stock prices collapse.

Greenspan is not amused by the second-guessing. He believes the wealth effect has added a percentage point of growth to gross domestic product each year over the past four years. He has also privately faulted the New York Fed study for failing to fully capture the stock market's impact on the economy. The report's main findings don't include consumer spending on durables such as cars and computers, whose sales are affected by the ups and downs of Wall Street. Steindel says the results are the same with consumer durables included.

So far, differences over the wealth effect have not caused splits in monetary-policy decisions. But that could change if the market's retreat turns into a rout while unemployment declines and inflation heats up. In that case, what seems like a dry debate over economic arcana could turn into something more: a full-fledged dispute over interest rates.

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