Put simply, the well-to-do, hugely compensated Americans contributing greatly to soaring prices is the class least damaged by the rampant inflation. So far, higher prices don’t seem to bother them and have done nothing to curb their record shopping spree. If deep-pocketed families feel the inflation pinch at some point, they harbor plenty of wiggle room to trim back by shortening vacations, ordering fewer features on a new Chevy Suburban, or dining out once instead of twice a week.

Instead, the big inflation partly spawned by the highly paid takes its stiffest toll on low-income Americans. Those hard-pressed folks typically don’t buy stocks and are most frequently renters, not homeowners. They’re the people driving the old cars leading the budget-busters list, and spend much more of their incomes on such essentials as gasoline and groceries. Since they’ve got less if any leeway to reduce spending on fun stuff such as restaurant meals and vacations, they suffer the full impact of gale-force inflation. “Forget supply-chain problems,” says Ed Pinto, former chief credit officer at Fannie Mae, and director of the American Enterprise Institute’s Housing Center. “The wealth effect hit in a big way around mid-2021, helping drive inflation, and what’s causing it is the Fed’s easy money policies.” As Wells Fargo analysts put it in a recent report on the phenomenon, “The spending [causing inflation] is steered by a select few”—meaning higher-income households.

Inflation is effectively a “tax” that falls most heavily on lower-income households. They devote much more of their incomes to buying goods and services than high-earners, who accumulate the savings to buy those houses and stocks that have risen so much in value. As Elon Musk put it in a recent tweet, “Inflation is the most regressive tax of all.”

The wealth effect’s sources

The wealth effect is a well-established financial lever that past Fed chairmen including Alan Greenspan and Ben Bernanke have praised, and succeeded in creating, via ultralow interest rate policies and, more recently, quantitative easing. Those policies raise asset prices, and hence spur consumer spending that lifts economic growth. Greenspan boosted the wealth effect to navigate the early 2000s dotcom collapse, and Bernanke deployed it to reboot expansion following the Great Financial Crisis. Without talking much about the wealth effect, current Chair Jay Powell invoked precisely the tools that generate it by pursuing both a zero interest rate and quantitative easing policy during the pandemic. Only this time, the wealth effect dwarfs its size in any previous period, to the point where it’s now the supercharged motor helping drive the inflation rampage.

As Pinto points out, economists generally posit that every $100 gain in wealth translates into a $3 or 3% increase in spending. As Americans’ wealth grows, they become more confident that their financial futures are assured. They’re willing to buy more now, knowing they can always sell those assets in the future for much more than they paid.

For Pinto, the wealth effect has four components.

• The first and biggest is the explosion in equity prices. In the year after recovering from the pandemic-induced swoon, the U.S. stocks have added $12 trillion in value. The wealth effect from those gains added $360 billion a year in extra consumption (3.0% of $12 trillion).
• The second factor is $6 trillion in home price appreciation, or HPA. “In almost every boom, it’s the lower end of the housing market that appreciates much faster than the high end,” says Pinto. “But for almost a year, the value of expensive homes has grown at the same rate as low-priced houses.” Here the contribution is another $180 billion. His AEI numbers show that high-end values have risen 27% since the start of 2020, and that the gains in the top quintile of homes account for an outsize share of the $6 trillion increase, given that the well-to-do have the highest homeowner rates, the priciest homes, and most equity.
• Third, the Fed-engineered sharp decline in rates enabled millions of homeowners to refinance at lower monthly costs. That break handed them $280 billion a year in extra cash.
• Fourth, as home equity grew, Americans rushed to tap that equity. Cash-out refis put an additional $90 billion in their pockets. The total wealth effect from the asset gains and using your house as a cash machine is over $900 billion. Its full impact hit the economy late last year and will continue well into 2022.

High-income consumers are a major force in driving the boom in spending—and inflation

To determine which income groups are doing the most new spending, Pinto used data from the Census Bureau and Commerce Signals, a Verisk company, to track debit and credit card expenditures by income quartile. Those card purchases account for 45% of all personal consumption and provide an excellent guide to overall spending trends, trends that can contribute to inflation. To simplify the analysis, he followed two groups, the highest and lowest quintiles. He also adjusted all numbers for inflation.

Pinto estimates that roughly 80% of the wealth effect goes to the highest quintile. This group owns 90% of all stocks and a huge share of all housing by market value. “In 2019, spending by the highest and lowest quintiles were moving together, and simply matching inflation,” says Pinto. Both suffered steep declines in the early days of the pandemic from March to late April 2000. The drop in the low-income cohort was shallower, and its comeback much more rapid. By September 2020, the lowest quintile had grown by almost 12% in “real terms” over “same month” 2019, and the spending numbers kept leaping. By September 2021, the lowest quintile had slowed to a still robust 6% gain year over year.

Why was the lowest quintile so resilient? As Pinto explains, those families benefited greatly from government cash outlays during the pandemic. Stretched homeowners were able to delay mortgage payments because of bank forbearance, and new regulations enabled renters and those with student loans to suspend payments.

By contrast, the highest quintile regained ground much more slowly. “In the early days of the crisis, the high end suffered a ‘reverse wealth effect,'” says Pinto. “The stock market cratered and the level of appreciation for high-end homes slowed, dropping from 5% to 2.8%. As the markets for both stocks and houses recovered, it took months for high earners to regain confidence and start spending part of the gains from the rise in prices of their assets.” Spending for the highest quintile didn’t return to 2019 levels until mid-October 2020, five months after the lowest tier broke even. By March 2021, the high end had raced to match the low tier in annual appreciation, and then the two rapidly increased in tandem until late August.

From there, inflation-adjusted spending in the lowest quintile slowed dramatically, while the highest income group stayed on a tear. Measured in consumption, the high tier took charge. For the week of Jan. 16, the low end increased just 4% year over year, while the top tier rose over three times as fast at nearly 12%. “Keep in mind that these numbers are adjusted for inflation,” says Pinto. “Add the CPI increase, and the high end was jumping at around 20%.”

The culprit?

For Pinto, the main culprit is the Fed. “Sure, housing prices and stocks rise in many markets, but seldom if ever at these rates or this much at the same time,” he says. “Around 60% of the wealth effect is attributable to the Fed’s zero interest rate policy and quantitative easing.” Pinto points out that the Fed’s stance hugely lifted stocks, and cheap mortgages drove up home prices. Pinto believes that the wealth effect will keep inflation raging for many months to come. The low earners will continue taking the brunt of the damage partly caused by high earners’ heavy spending. For a long time, it looked as though easy money was a free ticket to prosperity. Now we’re seeing its true costs and, most shocking of all, who’s paying.