Simply Put: Reverse wealth effect

Hari Viswanath |BL Research Bureau | Updated on: Jun 25, 2022

Central banks use this tool to cool the economy when inflation is red hot

Two friends catching up in a coffee shop got excited as their favourite MJ song from school days decades earlier, started playing. As they started humming in chorus…’all I want to say is that they don’t really care about us’ , they ended up getting into an interesting conversation.

Ram: I kind of get the feeling the central banks don’t really care about us any more!

Veena: Why on earth are you saying that?

Ram: My equity portfolio across the board, and especially investments I had made in US markets is crashing. But whether it is the Fed or many other central banks globally, they continue to increase interest rates which is negatively impacting markets. What happened to the so-called ‘central bank put’ - the unofficial guarantee that central banks will intervene to prevent excessive falls in equities and other asset classes!

Veena: Times are different now. With inflation in many developed economies at multi-decade-highs, their number one priority now is to bring it under control, even if it means slowing down the economy and inflicting losses in asset prices.

Ram: This sounds silly! Do they want people to get poorer and feel the pain of inflation even more?

Veena: Ha ha, no! What they are trying to do is curb some of the spending in the economy by either attempting to reduce the rate of increase in asset prices, or in times like now, outright reduce some of the asset prices. They may not explicitly state so. But that the central bank put has not been forthcoming despite huge losses in the stock and bond markets is an indication of that. This concept is known as the reverse wealth effect.

Ram: Sounds silly again! If asset prices fall, won’t I spend more and buy them as they are cheaper?

Veena: Is that so? Last year, you bought a flashy car without taking a loan. How did you manage that?

Ram: I made big gains in the stock markets. Along with my savings, that was sufficient to make full payment.

Veena: Right. Can you repeat it this year?

Ram: No way! This year I have only losses.

Veena: You got your answer there. This is how the wealth and reverse wealth effect play out. Central bank policies, amongst other things, attempt to stimulate economy via the wealth effect by making you feel wealthy during bad times, and cool the economy when inflation is red hot via the reverse wealth effect. It is also not just about the actual profits you make on your equities or other assets. Even when you have not cashed in on the gains, the psychological positive feeling you get from your notional gains can induce you to spend more and vice-versa.

Ram:  Ok. So, now the plan is to engineer reverse wealth effect as inflation is red hot?

Veena: Yes. The famous former Fed Chairman, Alan Greenspan, noted that when people have significant capital gains, a small part of it results in an increase in demand and boosts consumption. At the same time, supply may not increase proportionately, leading to inflation. From the time of the Covid-induced market crash in March 2020 till recent market correction, there has been significant capital gains in asset prices across the world. This too is one of the key contributing factors now for high inflation. So logically reversing some of these gains may be required to bring some balance between demand and supply.

Take note
Priority of central banks now is to bring inflation under control, even if it means slowing down the economy and inflicting losses in asset prices

Ram: But our inflation in India is not that bad as compared to developed economies.

Veena: Yes. The wealth effect and reverse wealth effect, as a way to influence economy, are strong tools in developed economies where standards of living are high across the population and financial investments are more widely held. In India too, it plays out, but to a lesser extent.

Ram: Interesting. So I understand if inflation has to cool down, reverse wealth effect has to play out. Now I realise they do care about us!

Published on June 25, 2022
COMMENTS
  1. Comments will be moderated by The Hindu editorial team.
  2. Comments that are abusive, personal, incendiary or irrelevant cannot be published.
  3. Please write complete sentences. Do not type comments in all capital letters, or in all lower case letters, or using abbreviated text. (example: u cannot substitute for you, d is not 'the', n is not 'and').
  4. We may remove hyperlinks within comments.
  5. Please use a genuine email ID and provide your name, to avoid rejection.

You May Also Like

Recommended for you