Home Equity 'Wealth Effect' Fuels Consumer Spending

Many analysts of the U.S. economy have been surprised by the strength and durability of consumer spending since 2000. One might have thought that the bursting of the tech stock bubble (stock values peaked in March 2000), the onset of recession (March 2001) and the tragedy of the September 11, 2001 terrorist attacks would have been sufficient to put a brake on personal consumption spending. In contrast, consumer expenditures have been one of the bright spots in the U.S. economy.

The strength of the housing market has been the reason for continued buoyancy in household spending. The robustness of overall housing demand has been fueled by low and declining mortgage rates. By June 2003, 30-year, fixed-rate mortgage rates had fallen to their lowest level in 45 years, sparking continued growth in home sales and new construction. The overall high level of housing demand has caused home values to increase — even after controlling for general consumer inflation. Higher home prices have led to growth in net household wealth through home equity accumulation.

Home Equity Versus Stock Equity

Across the United States, home equity grew by $2 trillion over the past three years, reaching $7.7 trillion by the end of March 2003, as shown in Exhibit 1. Home equity — the difference between the home value and the amount of mortgage debt on the property — is the single largest component of net wealth for most families in the United States. According to the 2001 Survey of Consumer Finance, home equity comprises 50 percent of household net wealth for one-half of all households. Thus, an increase in real home equity (that is, adjusting for general inflation) is a significant part of wealth building.

While home equity gains have been significant, the loss in stock market wealth has also been substantial. The Wilshire 5000, a broad measure of U.S. stock values, fell from its March 2000 peak of $14.3 trillion to $7.8 trillion by September 2002, a loss of $6.5 trillion. Why have the gains in home equity wealth had a more powerful effect on consumer spending than the loss of stock market wealth?

The answer lies in two facts. First, families view gains in home equity wealth as more "permanent," whereas gains (or losses) in stock market wealth are seen as more "transitory." Consumer spending is more likely to experience a wealth effect from permanent increases in wealth. Home equity growth is more stable largely because home values are far less volatile than stock prices. Since 1970, the quarterly growth rate of home values has averaged 6 percent (at an annual rate) with a standard deviation of 4.8 percent, while the market value of corporate equities has gained 15 percent on average with a standard deviation of 33.4 percent. Clearly, stock values have been far more volatile than house prices. As a consequence, aggregate home equity in the United States has grown 8.6 percent per quarter (annualized) with a standard deviation of 7.9 percent — far less variable than stock market gains.

Second, home equity wealth is more broadly held across the United States than is stock market wealth. The U.S. homeownership rate stood at 68 percent in the second quarter of 2003, while only 52 percent of American families hold stock either directly or indirectly. Further, homeowners comprised a wide cross section of demographic groups. Thus, when a rise in home values generates home equity wealth, both lower- and higher-income families gain. In fact, about three-quarters of all stock market wealth is held by the highest decile (top 10 percent) of income earners in the United States, and almost none by families whose earnings fall in the lowest third of the income distribution. Home equity wealth is more evenly distributed, with lower-, middle- and higher-income families benefiting from a general rise in home equity, as shown in Exhibit 2.

Empirical research has verified that the home equity "wealth effect" has a greater effect on consumption than do stock market moves. Based on estimates for 1984-2000 for the United States, an International Monetary Fund (IMF) study found that each one-dollar increase in housing wealth led to a 7-cent increase in consumption, whereas a one — dollar increase in stock wealth only caused a 4.5-cent increase. Research staff at the Board of Governors of the Federal Reserve System has also found stronger marginal propensities to consume arising from housing wealth. As reported by Fed Chairman Alan Greenspan, the effect on personal consumption expenditures generated from realized capital gains on home sales to be about 10 to 15 cents on the dollar, compared with a general "wealth effect" of 3 to 5 cents incorporating all components of household wealth. The IMF's latest World Economic Outlook has also reported larger wealth effects from home value changes than from comparable stock equity movements.