How the wealth effect is shaping the economy

Over the past year, there’s been a growing rift between upper-income consumers, who are continuing to go out and spend, and lower-income consumers, who’ve been pulling back. 

That gap is widening, in large part, because the labor market is weakening, putting a damper on wage growth. But there’s another factor behind the spending gap: the wealth effect.

The wealth effect is all about the assets that wealthy people own, including stocks, homes, savings accounts, and crypto. Those assets can literally allow people to spend more money — for instance, people can borrow against their home equity. Plus, just owning assets can have a psychological effect on people.

“They certainly can feel more confident to go out and spend more,” said Gabriel Chodorow-Reich, an economics professor at Harvard who’s studied the wealth effect. “Stock market goes up, and people make additions to their houses, but also spend on consumer services, goods.”

Chodorow-Reich said that kind of spending can have ripple effects. He found that in times when stocks are rising, local employment tends to pick up in wealthier regions — especially at businesses where wealthy people spend money.

“Restaurant spending is, by definition, local,” Chodorow-Reich said. “And it’s going to show up in more employment at local restaurants.”

The wealth effect has been propping up consumer spending over the past year, according to Shannon Grein, senior economist at Wells Fargo. 

“When you look at equity values, or the fact that homeowners own a near-record share of equity in their homes today, I do think these types of wealth factors are allowing your middle- to upper-income consumer to still have enough behind their balance sheet to keep spending,” Grein said.

The risk here, she added, is the wealth effect propping up the economy over the long run.

“This is just not a position that you want your economic system to be in, in general,” Grein said. “You want everyone to be contributing to growth, and spending, and having that discretionary income to do so.”

For now, at least, most people seem to; the wealth effect is not propping up the economy.

“Wealthy households are not responsible for all of consumer spending,” said George Pearkes, macro strategist at Bespoke Investment Group. “They’re not even responsible for half of it.”

Pearkes said even though the labor market has cooled, people with lower incomes are still spending plenty of money.

“We haven’t seen job losses, we’ve just seen slowdowns in hiring and a modest rise in the unemployment rate,” Pearkes said. “And as a result, we haven’t seen the sorts of spending slowdowns you would worry about if lots of people were losing their jobs.”

If the labor market heats up and wage growth picks up, Pearkes said that people with lower incomes are going to spend even more.

“They tend to see the strongest wage gains, strongest employment gains, during hotter labor markets,” Pearkes said. “That can then restart their consumer spending, and even out the distribution of where consumer spending has fallen throughout this year.”

And that would mean the wealth effect would play a smaller role in this economy.