Effect affect

Fed generates the wealth but where's the effect?

The so-called wealth affect looks overrated. Americans' private worth grew twice as fast as the US economy last year, according to Boston Consulting Group, due largely to the rise in stocks and other financial assets. But consumers aren't rushing to spend their gains.

That contradicts one theory behind the Federal Reserve's programme of bond-buying, or quantitative easing, now in its third act. The idea is that massive bond purchases, currently $85 billion-worth per month, suppress yields and encourage investors to buy riskier assets like stocks and corporate bonds and regular Joes to purchase homes. Then, rising asset prices make everyone feel wealthier and so more willing to spend. Finally, this greater demand for goods and services stokes faster economic growth.

QE has certainly juiced the markets. The S&P 500 Index, for instance, is up 13 per cent since the Fed, chaired by Ben Bernanke, announced its latest round of bond buying. And home prices are on the rebound, making many Americans richer, at least on paper. A new BCG study suggests their wealth increased by 8.1 per cent last year, while nominal GDP only expanded by 3.5 per cent.

Yet, one key linkage, the connection between rising asset prices and freer spending, seems missing. In April, US consumer spending actually fell 0.2 per cent in nominal terms. Though previous months showed at least modest increases, consumers still have reasons to keep their dollars in their wallets. The unemployment rate is still high and home prices, while rising, are well below their pre-crisis peaks. Moreover, paper gains can disappear, as many people learned in 2008.

It's impossible to know if consumers would be even less inclined to go to the mall if the Fed had done nothing. And, it could just be a matter of time before spending accelerates, with US consumer sentiment at its highest level in nearly six years in May, according to the Thomson Reuters/University of Michigan survey. Still, five years into quantitative easing, there isn't much to show in the real economy for expanding the Fed's balance sheet by $1 trillion. QE is an untested policy, and the non-appearance of the wealth effect is another reason to wonder whether it's the right one.