What's happened to the wealth effect?

The US household saving rate appears to have drifted up in recent months. This is surprising since the labour market has been strong and household wealth relative to income is around its pre-crisis peak. Normally this would be expected to lead to a reduction in saving via a positive wealth effect. One explanation is that households are saving the windfall from lower gasoline prices as they do not believe the price declines to be permanent. But it also seems as if US households have become more cautious in their spending and less sensitive to changes in their wealth.

There are several reasons why the wealth effect has been more muted:

1. Households only tend to borrow against the rise in equity beyond the purchase price. While negative equity is finally close to being eliminated, there is still not that much excess equity built up in housing to extract. The chart above shows the level of house prices finally returning to their previous peak. The second chart below shows that this recovery in house prices has almost restored housing equity as a share of housing asset values. The reason why this ratio did not rise further in the boom is that households extracted the increase in equity beyond a certain level.
2. Lending standards are stricter than pre-crisis. Home equity line of credit (HELOC) standards are much tighter than pre-crisis, so it is much harder to borrow against rising property prices.
3. Homeowners have been burnt by falling house prices. Households will probably be more cautious now because they realise house prices can fall. Before the housing market crash, most homeowners were under the delusion that house prices would only ever rise.

Going forward, if house prices continue to climb as we expect, this should become more supportive for consumer spending, but the wealth effect is unlikely to increase to the extent it did pre-crisis. As the saying goes "once bitten, twice shy".