Uncertainty compromises Fed’s 'Wealth Effect'

By JULIA ZHU, MEDILL NEWS SERVICE, Written for UPI   |   Nov. 16, 2012 at 2:22 PM
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WASHINGTON, Nov. 16 (UPI) -- Economic uncertainty is still haunting Americans. A week after the election, stock indexes tumbled drastically, compromising the "Wealth Effect" that the Federal Reserve is trying to achieve.

All three major U.S. stock indexes have dropped more than 5 percent since the day after U.S. President Barack Obama was elected to a second term and Republicans continue to control the House of Representatives while Democrats control the Senate.

As of Thursday, the Dow Jones industrial average was down 703.30 points since the election. After Obama's news conference Wednesday, the DJIA lost 185.23 points -- 1.45 percent.

"There is a sense that the United States is in a very dangerous precarious situation and don't know what's going to happen," said Meir Statman, a professor of finance at Santa Clara University in California and a recognized expert in behavioral finance. "So people who see that say, 'Maybe I'll take my money out until things calm down.'"

Investors worry about the potential "fiscal cliff" with more than $500 billion in tax increases and across-the-board spending cuts scheduled to take effect after Jan.1, unless Obama can reach an agreement with congressional leaders. They met Friday at the White House in the opening round of talks aimed at striking a deal.

"People in the investment industry have been talking about this for a long time, really since the spring. But this has finally come to the front burner for most retail consumers and investors," said Ron Florance, managing director of investment strategy for Wells Fargo Private Bank.

"We are definitely seeing tax gain selling. So they are harvesting gains this year while tax rates are lower than they will be next year," Florance said. "The problem with consumers is we are starting from such a low point. We've just bought them from a mood of catastrophe to kind of a mediocre mood."

The "Wealth Effect" is the premise by which as stock prices rise, investors feel more comfortable and secure about their wealth, causing them to spend more.

"There is a relationship between wealth and spend but that is also depending on how people feel about what the future is going to bring," Statman said. "And if they are not sure, then they spend less."

A report released Wednesday by the Commerce Department stated that U.S. retail trade sales fell 0.3 percent in October from September, the first drop in four months.

The "Wealth Effect" worked in September after the Federal Reserve announced a third round of quantitative easing, with the Fed deciding to purchase additional mortgage-backed securities at a pace of $40 billion per month.

In September, the DJIA jumped 346 points (2.64 percent) to 13,437. The Nasdaq composite 49.27 points (1.61 percent) to 3,116.23. The Standard and Poor's 500 increased 34.09 points (2.42 percent) and closed at 1,440.67 on Sept. 28.

A report released by the Bureau of Economic Analysis at Commerce Department says personal saving went down to $395.0 billion in September, compared with $445.1 billion in August. Real personal consumption expenditure, adjusted to price changes, went up 0.4 percent in September, compared with an increase of 0.1 percent in August.

However, the report said, real disposable personal income went down less than 0.1 percent in September, which indicates that people were spending more while they didn't actually make more.

"People spend more from their current earnings but, of course, people can also increase their spending based on money they have in the past, from savings and money they borrow, for example, charging on their credit card," Statman said. "That depends on how confident they are in getting income later on."

A Fed report released in early November stated that consumer credit increased at an annual rate of 5 percent in September. The $11.4 billion gain followed a revised $18.4 billion increase in August was better than the forecast.

"We saw people willing to invest a little bit more, borrow a little bit more and spend a little bit more. But a little bit, not a lot," Florance said.

"We are still in an area where consumers are very, very cautious. They are still recovering from the great recession and financial crisis. So even though they are feeling better, they are still very cautious.

"It all depends on Mr. (John) Boehner, Mr. (Harry) Reid and Mr. Obama. If those three can sit in a room and get along and come up with a reasonable solutions and everything is gonna be fine," Florance said. "It all depends on these three people."

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