When share prices hit records and house values climb, people tend to feel richer, even if they have not sold anything. Feeling richer, many of them spend a little more. Economists call this the wealth effect, and it helps explain why central banks pay attention to stock markets and house prices even though neither is officially part of their job.
What the wealth effect is
The wealth effect is the idea that changes in the value of people’s assets change how much they spend. If a household’s pension, share portfolio or home rises in value, it may save less out of its income and spend more, because its long-term finances look healthier. When asset prices fall, the opposite happens: people cut back to rebuild their savings.
The effect is usually modest for each pound of wealth. Research has often found that consumer spending rises by a few pence for every extra pound of household wealth over time. But because household wealth is so large, even a small effect can add up to a meaningful boost or drag for the whole economy.
Shares versus houses
Different kinds of wealth behave differently. Share ownership is concentrated among wealthier households, who already spend comfortably, so a stock market rally may lift spending less than its headline size suggests. Retirement savings are also locked away for many people, which limits how much they react to market swings.
Housing wealth is spread more widely, especially in countries like the UK where home ownership is common. Rising house prices can also make it easier to borrow against a home, for example by remortgaging. Some studies find a stronger spending response to housing wealth than to share wealth, though results vary by country and period.
Why central banks watch it
Central banks care about the wealth effect because it is one of the channels through which interest rates work. Lower rates tend to lift share and house prices, which encourages spending and supports growth. Higher rates tend to cool asset prices and with them spending. Our guide to real interest rates explains why borrowing costs matter so much for asset values.
It can also complicate their job. If a strong stock market keeps wealthy households spending freely, inflation may stay higher for longer even as rates rise. Some economists have argued that this helped keep US consumer spending resilient in recent years despite tighter policy.
What it means for markets
For traders, the wealth effect creates a feedback loop. Rising markets support spending, which supports company profits, which supports markets. That loop can make booms last longer than expected.
The danger is that it also works in reverse. A sharp fall in shares or house prices can hit confidence and spending at the same time, turning a market correction into an economic slowdown. That is one reason a big sell-off can become a self-reinforcing problem rather than a contained one.
Signs to watch
Useful signals include household net worth figures, which in the US are published quarterly by the Federal Reserve, consumer confidence surveys and spending on discretionary items like travel, restaurants and luxury goods. Our guide to the consumer discretionary sector covers the shares most sensitive to this kind of spending.
In the UK, house price indices and mortgage approvals are often a better guide than the stock market, given how important property is to household wealth.
The bottom line
The wealth effect links asset prices to everyday spending. It is small per pound, but large in total, and it means a booming market can keep an economy running hot while a crash can drag it down. Watching how wealth and spending interact helps make sense of why markets and the economy sometimes seem to move together. To test how well you understand these links, take the free Samuel & Co trader assessment.
