Christopher J. Neely

English

Research Papers in Economics

July 2000
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Stock Prices and
Consumption
By historical standards, equity prices now are
exceptionally high in comparison with current corporate
earnings.  In January 2000, the price-earnings ratio
(P/E)—the price of a typical stock to the earnings per
share—for the S&P 500 was 32.4.  Prior to 1999, the
average annual P/E ratio for the S&P 500 had never
been this high.  Such high valuations might indicate that
investors expect that corporate earnings will increase in
the future or that investors are now willing to accept
a lower average rate of return on equities than in the past.
Policymakers and other analysts have expressed
concern that high equity prices could increase current
consumption and aggregate demand, which could ignite
inflation.  This concern about asset prices reflects
economic theory, which suggests that people choose
to consume according to the present value of their
lifetime income.  Because wealth can be converted to
income, or vice versa, an unexpected rise (fall) in wealth
increases (decreases) consumption and aggregate
demand.  Increased demand might require higher interest
rates to balance savings and investment, so as to main-
tain price stability and sustainable growth.  Conversely,
a large fall in wealth might conceivably cause a sharp
decline in consumption and require lower interest rates.
Because equities are an important—and volatile—
component of overall wealth, the link between stock
prices and consumption has been carefully studied.
Has consumption growth been high historically when
equity prices were high, as reflected in the P/E ratio?
A very simple examination of this issue would be to
compare the January P/E ratio for the S&P 500 with
annualized aggregate consumption growth of non-
durables and services over that year.  It is appropriate
to restrict consumption growth to nondurables and
services as durable consumption goods provide grati-
fication over a long period of time, rather than in just
the current period.  The chart plots the annual growth
of consumption of nondurables and services against
the January S&P 500 P/E ratio of the same year.  The
sample extends from 1889 to 1999.  The chart shows
only a tenuous relation between consumption growth
and asset prices.  A similar exercise plotting changes
in P/E ratios during a year against consumption
growth also fails to reveal a strong pattern. 
These inconclusive illustrations are consistent with a
long line of research that has examined the relation
between asset prices and consumption with limited
success.  Although there are sound theoretical reasons to
believe that the rise in stock market wealth has fueled
high recent consumption growth and that consumption
is related to wealth in the long run, neither asset prices
nor other variables have proven especially useful in
predicting future consumption growth.  The weakness
of the relation makes it difficult to quantify the extent
to which recent stock price increases have fueled con-
sumption or to predict the likely consequences of a
sharp drop in stock prices.
—Christopher J. Neely
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10
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0
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4 8 12 16 20 24 28 32 36
January S&P 500 P/E ratio
1925
1908
1999
1895
1901
1917
1930
1932

Stock prices and consumption

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Stock prices and consumption

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Research Papers in Economics