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Markets and Economy

Will Consumers Stop Spending?

Late last year, volatility in the stock market erased roughly $3 trillion of household wealth, leading many analysts to wonder if consumer spending will slow dramatically this year. But the wealth effect is complex, and consumers don’t change habits overnight.

The stock market’s December tumble has reignited a debate over how wealth impacts the economy. When household equity portfolios lose value, how quickly do consumers start cutting back on purchases?

The consumer sector has accounted for 70 percent of US economic growth over the last 10 years. If households were to immediately adjust their spending habits in response to the market’s late-year losses of nearly 20 percent, the pullback could reduce consumer spending by a full percentage point, creating a significant headwind for economic growth in the coming year.

But the wealth effect gathers momentum slowly. Most people don’t adjust their spending habits unless they believe the change in their net worth will be permanent. Investors know the market is volatile, and short-lived swings rarely take a perceptible toll on consumer spending.

More Than Consumption

The consumer sector’s outsized footprint means even minor changes in spending habits will be significant for the broader economy. But the sector doesn’t necessarily dictate the economy’s growth. Despite accounting for 68 percent of all economic activity, consumer spending has only represented 64 percent of GDP growth since 2016. Capital investment from businesses has been the true economic driver in that same period, accounting for 29 percent of GDP growth even though it only makes up 13 percent of total economic activity.

How Sensitive Are Consumers?

Although it isn’t the only factor at play, a pullback in the consumer sector could still hurt growth. Over the long run, households do adjust their budgets in response to changes in their net wealth. In the 1980s and 1990s, the nation saw a positive wealth effect that boosted consumer spending and cut the saving rate in half.

In past decades, the gains from an unprecedented bull market enabled a long decline in the nation’s saving rate. The average household’s net worth rose from 4.75 times annual income in the late 1970s to a 6.5 multiple by 2005; consumers responded by spending more, cutting the average saving rate by more than half. Until the mid-1980s, most households were saving between 10 and 15 percent of their income; by 2005, the average saving rate had fallen below 5 percent. Once households began to trust the durability of their portfolio gains, they rationally decided to increase their consumption.

Not So Fast

While the saving rate often fluctuates in tandem with swings in household wealth, the relationship is complicated. In general, significant declines in wealth have coincided with recessions, which also are typically characterized by weak job markets and tight credit conditions. A recent study by the Philadelphia Federal Reserve attempted to isolate the wealth effect on household consumption during the Great Recession. The study, which looked at the financial conditions of individual households from 2006 to 2009, found negligible evidence of the wealth effect. Households cut back on spending during the real estate crisis, but their decisions appear to have been made in response to falling income and tighter lending requirements from banks, not the declining value of their homes.

A lost job or a closed line of credit could compel a household to change its habits, but cratering real estate prices—which could wipe out a considerable chunk of a household’s net worth—had negligible impact on spending decisions. It appears that homeowners trusted that housing priceswould eventually recover.

Lessons for Today

The behavior of homeowners during the last recession could have implications for consumer spending today. The market’s recent volatility erased roughly $3 trillion in household wealth, but the labor market remains strong and wage growth is lifting. As long as payrolls continue to grow, consumers are likely to wait patiently for the market to recover its losses.

Throughout the recovery, households have been patient with their spending. Net worth has fluctuated significantly over the past decade—dropping during the recession, then rallying to a new high last year—but the saving rate has held relatively steady at close to 6 percent. Consumer spending has also continued to grow along with the broader economy—regardless of the change in portfolio values.

Equities have already partially rebounded from their late-year slide, and with the labor market still making above-trend gains, households seem unlikely to start cutting back on spending now.

View our economic commentary disclaimer.

Jim Glassman

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