Economic supply (GDP) grew by 6.9% in fourth quarter of 1999 and has not slowed meaningfully so far,...
Economic supply (GDP) grew by 6.9% in fourth quarter of 1999 and has not slowed meaningfully so far, this year. The Fed expresses no problem with that per se. Demand (domestic output augmented by net imports) grew 7.2% in the fourth quarter of 1999 and has not slowed meaningfully so far this year. The Fed expresses no problem with that per se.
So, why is the Fed tightening policy? Greenspan at the recent Humphrey Hawkins testimony said: "What it is that we are concerned about is not the rate of increase in demand or the rate of increase in supply, but only the difference between the two." That is because the gap can be made up over time only by: foreigners lending the difference through trade and current account deficits (fine for now but unreliable for the long term); bringing new workers into productive employment (fine for now but you do eventually exhaust the pool of available workers); and/or inflation (fine for now - and the Fed wants to keep it that way).
The Fed's diagnosis is that stock market wealth effects on consumer spending is the main cause of the imbalance. The analytics lie in the intersection of the P/E multiple that capitalises income gains into stockmarket prices and the wealth effects that induce some of the incremental wealth to be consumed. The shorthand measure of the wealth effect used by the Fed is the ratio of wealth to income. This ratio has risen in recent years; although there is no prior reason to expect it to mean revert (there are several distinct sub-periods where it's settled, reflecting the underlying economic forces of the day).
Stock market wealth
It is not self-evident that the stock market wealth effect is the main reason why consumer spending is running so far ahead of income.
Around half of US households own stock either directly or indirectly (via retirement accounts, and the like). But the proportion of household wealth held in the stock market remains hugely skewed toward the wealthy, and increasingly so. More than 80% of household stockmarket wealth looks to be accruing to about 10% of households. For the average American, by far the largest share of wealth continues to sit in the family home.
And there is a clear mismatch between the (highly concentrated) distribution of stockmarket wealth and the (considerably less concentrated) distribution of consumer spending. The rich do not appear to be spending much, if any, of their stockmarket wealth. If they were, the distribution of consumer spending would be considerably more skewed than it is - and the gap between the growth of spending and income for the household sector overall would be larger than it is.
The side effects of a strong housing market is one way to rationalise the mismatch between consumer spending and income. The rate of home equity extraction has been high. This reflects extremely high turnover rates of existing homes and rapid acceleration in mortgage debt.
The housing market has slowed, but the level of turnover remains very high. A rallying Treasury market has meant that mortgage interest rates have stopped rising. Applications for new mortgages have fallen, but nevertheless remain very strong.
Dynamism in the housing market is linked to the stock market because the latter retains a good deal of symbolism. Hence stockmarket indices and survey measures of consumer confidence have become increasingly correlated over the course of the business expansion.
In fact, consumer surveys show that households react the same way to a move in the stockmarket whether they own stocks or not. Consumers look to be using the stockmarket as a shorthand way of assessing the health of the economy, something which is supported by the fact that headline stock indices do a better job of explaining the behaviour of consumer spending over a three to six month period than any of the consumer surveys.
Confidence effects are quite different in character from wealth effects. The latter provide a mechanistic link between the real economy and the stock market. Most time series analysis suggests that a $1 move in stockmarket wealth eventually leads to a 3 cents to 4 cents change in consumer spending. Greenspan has argued on a number of occasions recently that the wealth effect has added a full percentage point to growth over the past five years. In the same mechanistic vein, Greenspan argues stock prices need not fall to close the gap between spending and income, but aggregate stockmarket returns must be no greater than personal income growth (which are currently trending at about 6% per annum).
Confidence effects, on the other hand, cannot be easily calibrated. The stockmarket would probably have to slip noticeably and stay down for confidence to be brought down to levels that would slow spending in line with income. What's more, confidence is a self-feeding process. Small falls, for example, often have a tendency to become large ones. This is one argument in favour of a gradualist Fed policy adjustment, and is indeed one reason why we expect the Fed to continue to be gradualist.
Increases in oil prices should be assisting the Fed in meeting its objective. The headline Consumer Price Index has accelerated substantially from about 1.4% year on year (yoy) in October 1998 to 3.2% (yoy) currently, largely reflecting the impact of rising oil prices. In turn, real hourly wage growth has plummeted. The oil price increase is acting as a huge tax on spending power, which has nonetheless accelerated. There are a number of reasons for the apparent insensitivity of consumer spending to oil price (and interest rate) increases.
One factor has been the willingness of consumers to increase balance sheet leverage to maintain spending habits. In addition to the rapid growth in mortgage debt, there has also been a notable acceleration in the other forms of consumer borrowing. Nonetheless, total debt growth for t
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