The wealth effect might be shrinking

March 13, 2013: 6:05 AM ET
chart wealth effect
Although housing prices and stocks are up over the past year, some economists think consumers don't feel any richer.
NEW YORK (CNNMoney)

The Dow keeps hitting all-time highs and home prices are rising.

But many Americans do not feel any richer. That could be bad news for the economy.

"Consumers may be skeptical about their wealth," said Mark Zandi, chief economist at Moody's Analytics, in a research note.

In the past, consumers have spent more when stocks and the value of their homes were climbing -- even if they don't plan to cash out on those investments any time soon.

Economists call this the "wealth effect," but there are concerns that the impact on consumer spending isn't as pronounced as it used to be.

"Wealth effects appear to have shrunk since the 2007-2008 financial crisis" say Credit Suisse economists Neal Soss and Henry Mo, in a recent paper they call "Honey, I Shrunk the Wealth Effect."

Related: Construction jobs soar on housing recovery

Just a few years ago, economists estimated that for every $1 gain in stock market wealth, consumers spent about three cents more over a two-year period. Rising home prices were thought to pack even more bang for their buck, with each dollar increase leading to about eight cents more in spending.

If those relationships still hold true, the wealth effect alone could add one full percentage point to GDP growth this year, said Deutsche Bank's chief U.S. economist Joe LaVorgna, who believes the wealth effect is "as strong as it has always been."

LaVorgna thinks stock prices and home values will keep rising, and that people will spend more and save less.

But Zandi disagrees.

"Given that stock prices have been up, down, and all around over the past decade, households don't fully believe they are worth as much as their 401(k) statement says," he said. "At least not yet."

Thanks Fed! Dow hits all-time high

As for rising home prices? The value of houses in many hard-hit markets is still well below their peak levels from the real estate bubble days of 2005 and 2006. So the recent increases may only make those who bought recently feel richer.

"If you're lucky enough, you bought your house one or two years ago, and then, you may enjoy that wealth effect," said Credit Suisse's Mo. "But for a lot of people who were below water, they merely got back to where they were before the crisis."

Related: Economic 'skunk' stands by recession call

Mo said some consumers may spend more thanks to the housing recovery. But he suspects the boost from housing wealth will not be strong enough to offset the payroll tax hike that went into effect earlier this year.

If Mo is right, this is not good news for the Federal Reserve, which has been pumping money into the economy to try to stimulate growth ... and wealth.

As Fed chairman Ben Bernanke has said often, one of the goals of its many stimulus measures is to help average consumers.

"The point here is not to create what you'd call a faux wealth effect," Bernanke said in a Senate hearing two weeks ago. "The point here is to stimulate the economy, create some forward momentum in growth and employment, and that in turn shows up in earnings, and that creates a genuine increase in wealth."

So if the wealth effect is diminishing, that could mean the Fed will need to continue its stimulus even longer than previously expected. Soss and Mo wrote that the Fed may have to "engineer even larger bull markets in house prices and stock prices for any given desired pick-up in economic growth."

And in case you forgot, it was excesses in the stock and housing markets that helped lead to the last two recessions in the first place.

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