Understanding Trend and Cycle in Asset Values

This paper uses restrictions implied by cointegration to identify the permanent and transitory elements (the “trendÔand “cyclicalÔ) of household asset wealth. We focus our attention on a cointegrated system of three aggregate variables that are clearly central to the behavior of household spending: consumption, asset wealth and labor earnings. Because this cointegrated system is motivated by a budget constraint identity, the findings generated are applicable to a wide variety of theoretical structures. We find that the vast majority of variation in asset wealth is transitory and has no impact on consumer spending. Aggregate consumption can be well characterized by a linear combination of the random walk components of asset wealth and labor earnings; thus only the trend changes in these variables matter for consumption. By contrast, asset wealth has a large transitory component. Indeed, our estimates suggest that the vast majority of fluctuation in quarterly asset wealth–as much as 85 percent–is transitory. An implication is that the estimated marginal propensity to consume out of asset wealth only quantifies the effect of a trend change in wealth on consumption and therefore provides a misleading estimate of how much an arbitrary change, which mixes permanent and transitory shocks, affects consumption. We find no evidence that the serial correlation in quarterly spending growth, documented elsewhere, can be explained by a sluggish adjustment of consumption to permanent income or wealth shocks, as would be true in many recently popularized models with habit formation. Instead, the time series properties of aggregate consumption have a natural permanent income interpretation. When combined with a plausible reckoning of the way aggregate spending data are constructed, this permanent income interpretation can completely resolve the consumption smoothness puzzle documented in Campbell and Deaton (1989).