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When Will the Housing Market Recovery Boost Retail Consumption?
Some good news for the economy: August home prices were 12.4 percent higher than they were last year. Real estate constitutes about a third of Americans' net wealth, according to the Federal Reserve's Financial Accounts of the United States (previously Flow of Funds Accounts of the United States). So just using common sense, you'd think that strong growth in home prices might translate into stronger retail sales and a stronger economy. But real personal consumption expenditures remain sluggish, according to the Bureau of Economic Analysis, growing by just 0.2 percent in August and 0.1 percent in July.
Should we expect home price gains to translate into stronger retail sales? In a former post, Kris Gerardi outlined the debate between economists about how strong this "wealth effect" is. Most researchers estimate that the marginal propensity to consume (MPC) from home price gains is about 3–5 percent. That is, for every $100 increase in home price value, retail consumption rises by $3–$5. This may sound small, but in practice, this effect can be quite large: the 30 percent decline in home values from 2005–09 translates to a yearly $350 billion decline in retail sales. There hasn't been much research using household-level data, which we'd prefer, in order to control for omitted variable bias. One 2013 study (by Sumit Agarwal and Wenlan Qian), which looked at the wealth effect in Hong Kong from 2000 to 2002 using individual-level data, found a smaller 2 percent MPC.
In a recent paper, Karl E. Case, John M. Quigley, and Robert J. Shiller (hereafter CQS) find effects in the 2–6 percent MPC range. Their paper looks at quarterly U.S. home prices and retail sales, by state, from 1975 through second-quarter 2012. CQS estimate that, on average, when housing wealth increases, consumption rises by about 2 percent, and when housing wealth falls, consumption falls by as much as 6 percent. These findings suggest that it may not be easy for the wealth effect from a housing market recovery to be the primary spark to strong economic growth—home prices would have to rise much higher than 2005 levels to compensate for lost ground. Going back to our August 2013 data, the CQS estimates suggest that a 12.4 percent increase in housing wealth should correspond to a 0.4 percent increase in retail sales, which is not far off from what we are seeing: consumption growth that nonetheless falls short of a full recovery.
CQS also investigate whether the consumption elasticity of home price change is larger or smaller than that of the consumption elasticity of stock market change. They find that home prices have a bigger effect. You'd expect this to be true: household wealth forms a much larger fraction of household portfolios than stocks (29 percent versus 22 percent in 2012). And household wealth extends further into the middle and lower-middle classes, whom we might assume have a larger relative MPC than the wealthy.
In a recent working paper, Richard Ashley and Guo Li find that the impact of the wealth effect depends strongly on the persistence of the wealth change. Fluctuations with five quarters' to four years' persistence have the largest impact for housing wealth, while the stock market has the greatest effect when fluctuations are either a year or shorter, or longer than four years.
CQS identify two potential channels between home prices and consumption. The first is behavioral: when home prices decline, households may feel poorer, or predict they have lost a future income source when they sell their home. In response, they spend less. The second effect is more tangible and involves the use of homes as collateral. The Tax Reform Act of 1986, which gave tax incentives to mortgage debt, was followed by the fertile lending environment provided by the Great Moderation. During this era, American homeowners used their homes to pad their incomes, either by refinancing their mortgages and lowering their monthly payments or by taking cash-out refinances, home equity lines of credit (HELOCs), or other loans against their homes. According to a 2007 paper by Alan Greenspan and James Kennedy, from 2001 to 2005, American homeowners extracted $700 billion of equity each year through loans, cash-out refinances, and second mortgages. (That's $6,400 per household per year!)
So how do these two channels look in the current recovery? Some rough calculations suggest that the expectations channel is unblocked, but the credit channel is still constrained. The chart below shows in blue the market value of U.S. owner-occupied real estate per household. The chart demonstrates that housing wealth—as far as prices are concerned—has recovered on a per-household basis to 2005 levels, though not to where they would have been had they followed the upward trend from 1997 onwards. If consumption is driven by people's sense of home value, this channel could be considered "unblocked."
In green, the chart also shows homeowners' equity as a percentage of real estate. This gives a sense of how homeowners' assets have recovered relative to liabilities—or perhaps another way of thinking about it is as a measure of total loan-to-value. We can see there has been strong recovery in homeowner equity, due to the combined effects of deleveraging, write-downs, and price recovery (given the timing of the strong uptick in late 2011, the last is likely the most important). But on aggregate, we're still 10 percentage points lower than the precrisis average of 60 percent. To the extent that the wealth effect of housing is driven by cash flows and the use of houses as collateral for loans, this channel could be considered "blocked." If so, perhaps all that is needed is for home prices to recover a bit more.
By Elora Raymond, graduate research assistant, Center for Real Estate Analytics in the Atlanta Fed's research department, and doctoral student, School of City and Regional Planning at Georgia Institute of Technology, and
Carl Hudson, Director, Center for Real Estate Analytics in the Atlanta Fed's research department
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