Economic inequality matters for Federal Reserve monetary policymaking
After the U.S. Federal Reserve cut interest rates at the end of July, Fed Chair Jerome Powell suggested that inequality concerns influenced the decision when he underscored the importance of sustaining the economic expansion to reach “those left behind.” Powell’s concern is in line with the evidence showing that monetary policy affects income and wealth inequality, and rising inequality affects the effectiveness of monetary policies. Researchers and central bankers alike are increasingly calling for inequality concerns to play a central role in shaping Fed policy.
Economists have studied how monetary policy affects the distribution of income and wealth. A paper by University of Texas at Austin economist Olivier Coibion and his co-authors finds that expansionary monetary policies (lowering the benchmark interest rate) from the Fed reduce income and consumption inequality across households, while contractionary monetary policy shocks (by raising that benchmark rate) increase income and consumption inequality. The contrasting effects are primarily due to the differences in the composition of incomes and household balance sheets across the U.S. income distribution.
Other recent research from three economists at the International Monetary Fund that looks at 32 economies over recent decades supports these findings. In Confronting Inequality: How Societies Can Choose Inclusive Growth, Jonathan D. Ostry, Prakash Loungani, and Andrew Berg find that an unanticipated 100 basis-point decline in the interest rate lowers the Gini measure of inequality by 1.25 percent in the short term and by 2.25 in the medium term. The labor share of income rises, while the shares of income going to the top 10 percent, 5 percent, and 1 percent all fall. They conclude that there is clear-cut evidence that unanticipated, or exogenous, monetary policy easing lowers income inequality.
Economic inequality also affects the transmission of monetary policy to the U.S. economy in several ways. Wealthier households tend to have a lower marginal propensity to consume, meaning that low-income households will spend more of an extra dollar. Research by Stanford University economist Adrien Auclert shows that differences in marginal propensities to consume have an important impact on how interest rates affect aggregate demand. The stimulative effect of monetary policy is amplified when it shifts income toward individuals who are more likely to spend it—lower-income individuals and holders of debt.
Another way that inequality affects the effectiveness of monetary policy is through households’ access to financial markets and indebtedness. Because low-income households tend to have limited access to banks or financial markets, a change in the distribution of income affects who will be most affected by and more responsive to changes in interest rates. A household’s income and indebtedness profile also influence how it responds to a change in monetary policy. Research shows that the transmission of monetary policy is more effective for middle-class households that are more indebted and have adjustable interest rates on their debts.
Traditionally, economic inequality hasn’t been a primary concern to central bankers when it comes to monetary policy decisions. Liviu Voinea of the National Bank of Romania and Pierre Monnin of the Council on Economic Policies note that the decades-old dogma that central banks need not be concerned with income and wealth inequality was put into question following the global financial crisis, when many central banks used unconventional monetary policies to contain the economic fallout. Some economists argued that unconventional policies, such as quantitative easing (when central banks buy government bonds or other financial assets), would worsen wealth inequality because they boost asset prices more than the standard change in interest rates and because asset distribution is highly skewed toward wealthier households. In an ongoing debate, others argue that quantitative easing had positive distributional effects.
The jury’s still out on the effect of unconventional policies on economic inequality, but it’s clear that the distributional consequences of monetary policy are important to consider. Even if some Fed policymakers see inequality as irrelevant to their dual mandate of maximum employment and price stability, they still should pay attention to income and wealth inequality to maximize the effectiveness of monetary policy.