The urge to spend as a response to a sustained and unexpected change in ‘wealth’ is a predictable human response. Economists have studied this so-called wealth effect, in which an increase in wealth directly causes households to increase their consumption and correspondingly, decrease the amount they save.
The wealth effect resulting from the rapid appreciation of real estate assets has been a powerful stimulus to consumer spending and has increasingly captured the attention of central bankers. The chief economist at Merrill Lynch estimated that the wealth effect from housing accounted for 50% of US GDP growth in the first half of 2005.
Many countries have experienced housing booms over the past eight years, while the US has been playing catch-up, particularly in the past year.
Percentage change in housing values in selected countries over recent time periods:
The rise in housing values can vary considerably between regions because demand and supply are not only driven by macro factors, such as low interest rates, but also by local characteristics such as the rate of migration and job growth within a region. Federal reserve Chair Alan Greenspan noted in his address to the US Congress in mid-July that, “there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.” Bubble-like candidates include Las Vegas, Los Angeles, Miami, San Diego and Seattle.
Financial institutions have made it easy to tap into housing wealth through interest-only home equity lines of credit. As a result of rising property values, this form of homeowner debt has grown rapidly in popularity. According to the Bank Credit Analyst, a Canadian research firm, loans secured by property now account for 53% of banks’ total lending, up from 30% two decades ago. Borrowers are now more exposed to increasing interest rates, as a rise in interest rates would immediately increase interest payments on this form of debt and eat into monthly cash flow. Equally important, the line of credit does not require principal repayments; in fact, the line can be accessed to increase one’s debt, up to the individual’s limit. This contradicts the age-old financial planning wisdom of eventually gaining 100% equity in one’s house by way of the monthly principal repayment with a conventional mortgage.
Despite the growth in lines of credit, a recent RBC Financial Group report concluded that “…overall consumer borrowing patterns have been found not to be excessive and the annual pace of household debt growth today is significantly lower than it was in the 1970s and 1980s.”
Stock market versus housing wealth effects
Studies of the wealth effect caused by a rising stock market were inspired by the tech boom/bust in the equity markets. A 2001 paper published by the US Federal Reserve documented a dramatic behavioral response of wealthy Americans to the stock-market boom that prevailed from 1994 through 1999, and demonstrated that the magnitude of this response could account for the decline in the aggregate personal saving rate. At that time, wealth models showed that US consumers increased annual spending by about 4 cents for every dollar of additional wealth. After the bursting of the tech bubble, the Fed estimated that the resulting negative wealth effect held back consumer spending by about 1 ½% in 2002 and a lagged impact continued to dampen expenditure growth for approximately two more years.
There are differences, though, in the wealth effect generated by increases in the stock market versus the real estate market. A 2003 Bank of Canada Working Paper found that for the US economy, the tendency to consume as a result of housing wealth could be an increase of as large as 20 cents per dollar. Homeowners view gains in real estate values as more permanent. In contrast, gains in stock prices are viewed as more volatile and not necessarily lasting. A 2004 study found that within one year, about 80% of the housing wealth effect is realized, whereas it takes almost five years for stock wealth to approach 80% of its long run impact. More importantly, though, housing wealth has a broader reach. Stock market wealth effects are associated with older, wealthier groups; the top 1% of US stockholders control around one third of stock wealth. A greater proportion of the population, approximately 70% in Canada and the US, owns a home and this is spread more evenly across age and income brackets.
The eventual slowdown
Given that the housing wealth effect is a powerful influencer on consumer spending, it is not surprising that the US Federal Reserve continues to raise interest rates in an attempt to dampen consumer spending and offset the housing wealth effect. Ninety percent of economists recently surveyed by the National Association for Business in the US said that they expected the Federal Reserve to continue to raise interest rates. Interest rates on home equity lines of credit are typically ‘variable’ and will rise as the central bank’s rate rises. Higher interest payments (along with higher gas prices) are taking a larger chunk of consumers’ disposable income.
Given rising interest rates in Canada and the US, housing prices are expected to decelerate and may even decline, again depending on the region. Since the mid-1970s there have been two extended declines in real home prices in the US (1979-1982 with a 12.4% decline and 1988-1990 with a 14.55% decline). Given that consumer spending accounts for two-thirds of total economic activity, the resulting negative housing wealth effect on consumer spending could become a contributing factor to a slowdown in the US economy.