Did homeowners binge on sweaters or stocks?

In just eight words, the Federal Reserve waded deeper into a touchy debate over whether consumer spending can stand up to a housing market downturn.

At issue is how Americans spent hundreds of billions of dollars extracted from their home equity during a five-year housing and refinancing boom. Did they buy mostly sweaters and big-screen televisions, or stocks and bonds?

It may sound like a trivial argument, but depending on the answer it could mean the difference between a mild U.S. economic slowdown and a consumer-driven recession.

In its closely watched statement following Tuesday's Federal Open Market Committee meeting, the central bank reiterated its view that the economy seemed likely to expand at a moderate pace despite the slumping housing market.

It said this forecast was supported by solid growth in employment and incomes. Eight trim words.

By mentioning employment and incomes -- the first time in two years the labor market has been mentioned in the growth discussion -- the committee seems to have made their peace with the strength of the labor market, as well as noting a reason consumer spending could remain strong even when household wealth is stalling, J.P. Morgan economist Michael Feroli said.

The debate over the impact of mortgage equity withdrawal has been running for years, with luminaries such as former Fed Chairman Alan Greenspan and current Chairman Ben Bernanke disagreeing on the extent to which consumers used home equity to finance a spending spree that appears to be tapering off.

Greenspan and co-author James Kennedy wrote in a recent paper that home equity loans may have added close to 3 percent a year to consumer spending in recent years.

But Bernanke and others argue that a large portion of the money went to pay down debt or buy other assets, such as stocks and bonds, so even without a booming housing market, consumers will likely feel flush enough to keep spending.

'WHISTLING PAST THE GRAVEYARD'

Consumer spending accounts for more than two-thirds of U.S. economic activity, so Wall Street has reason to be obsessed with the state of the consumer.

The most recent economic data suggest consumers have pulled back, with spending advancing at a paltry 1.3 percent annual rate in the second quarter.

Investors will get a closer look at summer spending trends on Thursday, when major retailers release July sales figures and consumer electronics chain Best Buy Co. Inc. hosts a meeting with analysts.

The spending slowdown has coincided with a drop in the pace of home equity withdrawal. Mortgage finance company Freddie Mac said it expects cash-out refinancing activity to slow further in the second half of 2007 as credit terms tighten and house prices cool.

According to updated data provided by Greenspan's co-author Kennedy, net equity extraction equaled 3.4 percent of disposable income in the first quarter of 2007, down from a high of 10.5 percent three years ago, the middle of the housing boom.

Kennedy's data, which goes back to 1990, shows that before the Greenspan-led Fed began cutting interest rates in early 2001, net equity extraction rarely amounted to more than 4 percent of disposable income.

Economists who believe cash-out refinancing paid for a spending boom also point to a recent drop in sales tax revenues in California and Florida, two of the states with the biggest housing runups earlier this decade -- and the hardest falls.

Chairman Bernanke is whistling past the graveyard if he thinks that the housing recession is not going to negatively affect consumer spending via declining (mortgage equity withdrawal), said Paul Kasriel, director of economic research for Northern Trust in Chicago.

Not everyone on Wall Street agrees. Bear Stearns economist David Malpass wrote in a Wall Street Journal editorial this week that houses are not the be-all and end-all of the economy. Jobs matter more.

In a sign of how fiercely this debate rages, Malpass immediately drew fire from Barry Ritholtz, market analyst at Ritholtz Research and Analytics, who called the piece idiotically child-like in its bad facts and poor arguments.

Any analysis ... which claims 'Neither the economy nor job growth has been dependent on housing' is simply a case of reductio ad absurdum, he added on his blog.