The Wealth Effect
One of the signs of an economy that is starting to heat up is the wealth effect. The wealth effect is a phenomenon in which people start to increase their spending when they feel more secure. We see the wealth effect when people’s retirement plans, brokerage accounts and home values are making new highs, even though those investments are meant for long term goals. When their long term investments are higher, people feel they can spend some of their money now.
The Investment Company Institute put the combined total of retirement accounts in the USA at an all time high figure of $4.8 trillion as of March 31, 2016. Home values are also climbing steadily and are at all time highs in some parts of the country.
During the Great Recession of 2008 and 2009, a lot of Americans had to cut back on their lifestyle spending. Living within their means lead to an increased savings rate.
“Americans’ personal savings rate – which measures the public’s personal savings as a percentage of overall disposable personal income – has climbed right along with income, indicating that the country’s consumer base is increasingly pocketing their extra earnings rather than immediately splurging. The rate hit 5.4 percent in March, tying the month for the highest savings rate seen in the domestic economy since the end of 2012.” – US News and World Report.
Furthermore, the Federal Reserve’s low interest rate policies have helped to increase stock market valuations and home values. The Fed has showed no signs of increasing the interest rate significantly anytime soon.
When you put these factors together, people become more likely to spend money. This increased spending leads to an increase in economic activity. Increased consumer spending can lead to more companies producing more products and services and therefore hiring workers. This increases the number of workers with money who are feeling good about their finances, and the cycle starts to feed itself.
I see anecdotal evidence the wealth effect is starting to warm up as I go about my day. I see home remodeling on every fifth house in our neighborhood. I see people driving new cars. I see long waits at restaurants and lots of families at resorts.
The Labor Department’s most recent jobs data, released on August 5th, gave objective evidence the business cycle is continuing to expand.
All these observations lead to the conclusion that the wealth effect is heating up the economy. This should lead to a cycle of greater economic growth. If the wealth effect continues, we should see both an increasing stock market and real estate market over the next few years.