Has the Fed’s ‘Wealth Effect’ made YOU any richer?

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by Bill Nall,

from Money & Markets,

the Fed’s belief in the so-called “wealth effect.” In a nutshell, the wealth effect is supposedly a boost in consumer spending that occurs because of an increase in consumer wealth. With consumer spending accounting for almost 70 percent of U.S. GDP, it’s understandable why the Fed has focused its policies on the consumer.

Indeed, former Fed Chair Bernanke said it this way in an opinion column for The Washington Post on Nov. 5, 2010: “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Following Bernanke’s lead, current FOMC Chair Janet Yellen said this in the Jan. 20, 2014 issue of Time magazine: “And part of the [economic stimulus] comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.”

The problem is that the wealth effect — if it exists at all — is not working.

And as a result, the Fed has been continuously overly optimistic regarding its expectations for economic growth in the United States since the financial crisis ended in 2009. If the Fed’s annual forecasts had been realized over the past four years, then at the end of 2013 the U.S. economy would have been approximately $1 trillion larger, and many of our current economic woes and corporate earnings concerns would be behind us.

So where was the wealth effect in 2013?

If the wealth effect was as powerful as the Fed believes, consumer spending should have turned in a stellar performance last year. Recall that since their lows posted almost five years ago, stocks have risen an amazing 170 percent.

And in 2013 alone, the stock and housing markets posted large gains. Highly regarded bond manager Hoisington Investment Management Company reports that on a yearly average basis, the real-inflation-adjusted stock market index, as measured by the S&P 500, increased in 2013 by a whopping 17.7 percent, and the real-inflation-adjusted Case Shiller Home Price Index posted a strong 9.1 percent gain as well.

The combined increase in these wealth proxies of 26.8 percent was the eighth-largest gain in the 84 years of data collection. Yet, real per capita personal consumption expenditures (PCE) gained just 1.2 percent, which ranked a weak 58th out of the 84 years. What’s more, the difference between the increase in stock market and housing wealth as measured against the increase in PCE was the fifth-largest of the 84 observations!

What does all of this mean?

Put simply, it means that 2013′s eye-popping stock market returns and solid housing price gains did not translate into any meaningful increase in consumer spending as reported in the chart below. Such a huge discrepancy in economic performance, occurring as it did in the fourth year of an economic expansion, raises serious doubts about the reality of the wealth effect.

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