Takeaways
- Falling stocks over the past few weeks could undermine consumer spending by reducing the "wealth effect."
- Consumer spending has been boosted by wealthy households, partly due to their feeling of flushness after years of rising stocks prices.
- The "wealth effect" is about four times as big as it usually is, so falling stocks could prompt more belt-tightening than normal, according to one analysis.
President Donald Trump and his advisors have dismissed falling stock prices, saying they’re more focused on the “real economy”—but falling stocks could undermine one of the main forces supporting job growth, economists say.
After financial markets plunged last week, sending the S&P 500 stock index into correction territory, Trump and his top economic advisors dismissed concerns about the economy’s future. As the saying goes, a stock market does not represent the economy. Even if it reflects the expectations of business leaders about where the economy will be headed, it is still not the economy.
"Doesn't concern me," Trump said last week when a reporter asked him about the plunging stock market. "I think some people are going to make great deals by buying stocks and bonds and all the things they're buying. I think we're going to have an economy that's a real economy, not a fake economy."
However, there's at least one way the stock market can impact the real economy, to the extent that the "real economy" consists of people's ability to go to work, get paid, and buy goods and services.
Consumer spending is the main engine of U.S. economic growth as measured by the Gross Domestic Product, and falling stocks could throw some sand in that engine's gears. That's because over the past few years, as inflation has eroded the buying power of U.S. households, wealthier consumers have been increasing their share of the shopping, propped up by a formerly booming stock market.
The top 10% of earners were responsible for almost half of all consumer spending, the highest share recorded in data going back to 1989, according to an analysis by Moody's Analytics for The Wall Street Journal.
The Wealth Effect
Wealth effect is a phenomenon in which people tend to buy more when they are feeling wealthy.
The recent sell-off could lead to a recession because higher-income households are more likely to own stocks. This could trigger a domino-effect leading to a downturn: less spending would mean that businesses are less likely to hire and fewer people would get paid.
The steep rise of stock prices in the past four-year period has made the “wealth factor” stronger than it normally is. Oxford Economics developed a model that showed the wealth effect has a four-fold impact on consumer expenditures. This leaves the economy particularly vulnerable if this effect disappears.
Retail sales plunged in January, and only modestly recovered the following month.
“If the drop continues, it would negatively impact consumer spending,” Ryan Sweet wrote in a last-week commentary. “Household wealth is more important than ever for the consumer spending forecast. A stronger wealth impact has been a tailwind in terms of overall consumer spending. However, it could turn into a drag if the market falls.
