NCPA - National Center for Policy Analysis

Household Spending Sensitive to Real Interest Rates

July 16, 2015

A new study published by the Federal Reserve Bank of New York finds that households spend and invest in response to future expectations about real interest rates. They could have a higher rate of growth in future consumption due to higher returns to savings, or they could choose to consume more at the present and thus decrease the future growth rate in consumption. The elasticity of intertemporal substitution (EIS) is the net effect of these choices on future consumption.

The study finds a robust, significant relationship between expected consumption growth and expected inflation that implies an estimated subjective EIS of 0.8 in the general population. The research also revealed that the EIS is slightly higher for those households reporting higher income.  Simply put; most households are sensitive to changes in real interest rates.  Higher income households are even more sensitive.

Aside from identifying the importance of this key parameter, the findings have important implications for monetary policy. For instance, previous papers have found a very weak relationship between expected inflation and readiness to spend.  This suggests that the Fed's "forward guidance," through which its monetary policy affects spending at the lower bound on nominal interest rates, might be less powerful than indicated by many macroeconomic studies. However, the robust, positive relationship between expected consumption growth and inflation documented in this study supports evidence for the "forward guidance" channel's effectiveness.

Source:  Richard Crump et al., "Subjective Intertemporal Substitution," Federal Reserve Bank of New York, Staff Report No. 734, July 2015


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