Why Yellen Doesn’t Need to Worry About Spooking U.S. Consumers

Fed's Data Dilemma: To Tighten or Not to Tighten?

Federal Reserve Chair Janet Yellen has a lot to worry about as she gets ready to raise interest rates for the first time in almost a decade. One concern she may be able to put aside: Spooking U.S. shoppers.

Consumers, whose spending accounts for almost 70 percent of the U.S. economy, aren’t as sensitive as they used to be to declines in the value of stocks and bonds that typically follow an increase in interest rates, according to economists at JPMorgan Chase & Co. and Moody’s Analytics Inc.

“Asset prices have been rising over the past few years, and we haven’t seen a big consumption boom, so we’re not expecting a big decline if asset prices go down,” said JP Morgan economist Jesse Edgerton.

Edgerton and a colleague, Michael Feroli, calculated that the so-called wealth effect -- the impact of changes in household wealth on spending -- is only half as strong as it was before the 2008-2009 recession.

For every extra dollar in wealth since early 2008, consumer spending has risen by 1.7 cents, they estimate. That’s down from 3.9 cents in the period from 1952 until the last expansion ended in December 2007.

Several drivers could be causing the decline, among them reluctance to count on stock market gains after watching prices plummet in the Great Recession. Additionally, growing inequality has left financial assets concentrated in fewer hands.

Regardless, the reduced wealth effect matters as a Fed rate increase approaches: Tightening monetary policy can drive asset prices down, making consumers’ portfolios less valuable.

Diminished Effect

“Usually right around the first rate hike, the stock market doesn’t do very well,” said Ryan Sweet, director of Real-Time Economics at Moody’s Analytics in West Chester, Pennsylvania. This time, with the diminished wealth effect, “a garden-variety correction, I don’t think that would be a significant setback for consumer spending.”

The Standard & Poor’s 500 Index is trading around 1.3 percent lower than its record closing high of 2,130.82 on May 21.

A Fed rate increase affects consumer spending in other, conflicting ways. While it makes borrowing to buy a house or a car more expensive, it also increases income from savings accounts. While more interest income can spur spending, higher yields can also encourage more saving.

Putting all of the effects together, JPMorgan forecasts that each 1 percentage point increase in the benchmark federal funds rate will cut consumer spending growth by just 0.1 percent. That compares with a 0.16 percent decrease in consumption growth during the tightening cycles in 1994 and 2004.

September Liftoff

The Fed will probably raise the benchmark rate at its Sept. 16-17 meeting, according to 77 percent of economists in a Bloomberg survey conducted Aug. 7-12. Investors are less convinced, giving a 48 percent probability to a move next month, based on pricing of federal funds futures contracts. The Fed has kept the rate near zero since December 2008 to help spur a recovery from the deepest recession since the 1930s.

Fed officials have stressed that after liftoff, rates are likely to rise only gradually. In June, they forecast that the fed funds rates would be just 1.625 percent at the end of 2016.

In contrast, during the policy-tightening cycle that began in 2004, the Fed raised rates by a quarter percentage point at every FOMC meeting, starting with a shift to 1.25 percent in June. By June 2005 the fed funds rate was 3.25 percent, and it stood at 4.25 percent by the end of that year.

Buying Power

The gradual pace of increases may curb their economic impact, said Sam Bullard, an economist at Wells Fargo in Charlotte, North Carolina. What’s more, even if Fed rate increases reduce the wherewithal of Americans to spend, other economic developments will aid buying power.

“Consumers and households are in a better position than they were,” Bullard said. “We’ve been seeing good gains in monthly nonfarm-payroll growth, with those gains we’re seeing more income growth, and hopefully as we continue to move toward full employment we’ll see stronger wage growth as well.”

Unemployment has fallen to 5.3 percent, from a peak of 10 percent during the last recession, and the economy has added 211,000 jobs per month on average so far this year. Wages have been slow to rise in this recovery and expansion, but they should accelerate as the labor market continues to tighten, Sweet said -- further boosting the consumer.

“We could have all of these cross-currents, the Fed raising interest rates, equity prices sputtering -- in the end, what’s going to matter is wages,” Sweet said.