Innocent bystanders? Monetary policy and inequality in the US

Olivier Coibion, Yuriy Gorodnichenko, Lorenz Kueng, John Silvia

There are several conflicting channels through which monetary policy could affect the distribution of wealth, income, and consumption. This column argues that contractionary monetary policy raised inequality in the US, while expansionary monetary policy lowered it. This evidence stresses the need for monetary policy models that take into account heterogeneity across households. Current monetary policy models may significantly understate the welfare costs of zero-bound episodes.

“In recent decades, the Fed has given way completely, at the highest level and with disastrous consequences, when the bankers bring their influence to bear… As the American economy begins to improve, influential people in the financial sector will continue to talk about the need for a prolonged period of low interest rates. The Fed will listen. This time will not be different.” Acemoglu and Johnson (2012)

Recent popular demonstrations such as the Occupy Wall Street movement have made it clear that the high levels of inequality in the US remain a pressing concern for many. While protesters have primarily focused their ire on private financial institutions, the Federal Reserve has also been one of their primary targets. The prevalence of “End the Fed” posters at these events surely reflects, at least in part, the influence of Ron Paul and Austrian economists who argue that the Fed has played a key role in driving up the relative income shares of the rich through expansionary monetary policies. But this view is not restricted to Ron Paul acolytes. As the quote above from Acemoglu and Johnson (2012) illustrates, the notion that expansionary monetary policy primarily benefits financiers and their high-income clients has become quite prevalent. For example, Mark Spitznagel, a prominent hedge fund manager, recently published an opinion piece in the Wall Street Journal titled “How the Fed Favors the 1%” (Spitznagel 2012).

Possible channels linking monetary policy and inequality

Proponents of this view focus on two channels through which monetary policy affects inequality.

Heterogeneity in income sources

While most households rely predominantly on labour incomes, for others financial income, business income, or transfers may be more important. If expansionary policy raises profits by more than wages, wealth will tend to be reallocated toward the already wealthy.

Financial market segmentation.

Money supply changes are implemented through financial intermediaries. Increases in the money supply will therefore generate extra income, at least in the short run, for financiers and their high-income clients.

However, there are in principle a number of other channels through which monetary policy could also affect inequality.

Portfolio effects

If some households hold portfolios which are less protected against inflation than others, then inflation will cause wealth redistribution. For example, low-income households typically hold a disproportionate share of their assets in the form of currency.

Heterogeneity in labour income responses

Low-income groups tend to experience larger drops in labour income and higher unemployment during business cycles than high-income groups.

Borrowers versus savers

Higher interest rates, or lower inflation, benefit high net worth households (savers) at the expense of low net worth households (borrowers).

While the portfolio channel goes in the same direction as those emphasised by the Austrian economists, the other two channels point to effects of monetary policy that go precisely in the opposite direction: contractionary (rather than expansionary) monetary policy will tend to increase inequality.

What does monetary policy actually do to inequality?

In light of these different channels, the effect of monetary policy on economic inequality is a priori ambiguous. In a recent working paper (Coibion et al. 2012), we study how inequality responds to monetary policy shocks and which channels drive these dynamic responses. Our measures of inequality come from detailed household-level data from the Consumer Expenditures Survey (CEX) since 1980. While the survey does not include the very upper end of the income distribution (i.e. the top 1%), which has played a considerable role in income inequality dynamics since 1980, the detailed micro-data do allow us to consider a wide range of inequality measures including labour income, total income, and consumption. In addition, the Consumer Survey is available at a higher frequency than other sources.

Using these measures of inequality, we document that monetary policy shocks have statistically significant effects on inequality:

A contractionary monetary policy shock raises inequality across households.

Figure 1 below illustrates the impulse responses (and one standard deviation confidence intervals) for total income and total household expenditures, where inequality is measured using the cross-sectional standard deviation of logged levels, to a contractionary monetary policy shock.

Figure 1. Responses of income and expenditure inequality across households

These results are robust to the time sample, econometric approach, and the treatment of household observables and hours worked. Thus, the empirical evidence points toward monetary policy actions affecting inequality in the direction opposite to the one suggested by Ron Paul and the Austrian economists.

Why does economic inequality rise after contractionary monetary policy?

Because of the detailed micro-level data in the Consumer Expenditures Survey, we can also assess some of the channels underlying the response of inequality to monetary policy shocks. For example, Figure 2 below plots the responses of different percentiles of the labour earnings distribution to contractionary monetary policy shocks.

Figure 2. Response of labour earnings and total income by percentile

Monetary policy shocks are followed by higher earnings at the upper end of the distribution but lower earnings for those at the bottom. Thus, there appears to be strong heterogeneity in the responses of labour earnings faced by different households. Strikingly, the long-run responses of labour earnings and consumption (not shown) for each percentile line up almost one-for-one, pointing to a close link between earnings and consumption inequality in response to economic shocks. Thus, heterogeneity in labour income responses appears to be a significant channel through which monetary policy affects inequality.

Figure 2 also plots responses of total income, defined as labour income and all other sources of income, after a contractionary monetary policy shock. While the responses of total income at the upper end of the distribution are almost identical to those for labour earnings, those at the 10th and 25th percentiles are shifted up significantly. This reflects the fact that lower quintiles receive a much larger share of their income from transfers (food stamps, Social Security, unemployment benefits, etc.) and that transfers tend to rise (albeit with a delay) after contractionary shocks, thereby offsetting lost labour income. Hence, transfers appear to be quite effective at insulating the incomes of many households in the bottom of the income distribution from the effects of policy shocks. As a result, the dynamics of total income inequality primarily reflect fluctuations in the incomes of households at the upper end of the distribution. This illustrates that the income composition channel, particularly for low-income households, is also a key mechanism underlying the effects of monetary policy on income inequality.

Because the Consumer Expenditures Survey does not include reliable measures of household wealth, it is more difficult to assess those channels that operate through redistributive wealth effects rather than income. For example, in the absence of consistent measures of the size of household currency holdings or financial market access, we cannot directly quantify the portfolio or financial market segmentation channels. Nonetheless, to the extent that both channels imply that contractionary monetary policy shocks should lower consumption inequality, the fact that our baseline results go in precisely the opposite direction suggests that these channels, if present, must be small relative to others. However, in the case of the redistributive channel involving borrowers and savers, we can provide some suggestive evidence of wealth transfers by identifying high and low net worth households as in Doepke and Schneider (2006), namely that high net worth households are older, own their homes, and receive financial income while low net worth households are younger, have fixed-rate mortgages and receive no financial income. As illustrated in Figure 3 below, while the responses of total income for the two groups are statistically indistinguishable, consumption rises significantly more for high net worth households than low net worth household after contractionary monetary policy shocks, consistent with monetary policy causing wealth redistributions between savers and borrowers.

Figure 3. Response of income and consumption for high and low net-worth households

Conclusion

While there are several conflicting channels through which monetary policy may affect the allocation of wealth, income, and consumption, our results suggest that, at least in the US between 1980 and 2008, contractionary monetary policy actions tended to raise economic inequality or, equivalently, expansionary monetary policy lowered economic inequality. To the extent that distributional considerations may have first-order welfare effects, our results illustrate the need for models with heterogeneity across households which are suitable for monetary policy analysis. In particular, the sensitivity of inequality measures to monetary policy actions points to even larger costs of the zero-bound on interest rates than is commonly identified in representative agent models. Nominal interest rates hitting the zero-bound in times when the central bank’s systematic response to economic conditions calls for negative rates is conceptually similar to the economy being subject to a prolonged period of contractionary monetary policy shocks. Given that such shocks appear to increase income and consumption inequality, our results suggest that current monetary policy models may significantly understate the welfare costs of zero-bound episodes.

References

Acemoglu, D and S Johnson (2012), “Who Captured the Fed?” The New York Times Economix.

Coibion, O, Y Gorodnichenko, L Kueng, and J Silvia (2012), “Innocent Bystanders: Monetary Policy and Inequality in the U.S”, NBER Working Paper 18170.

Doepke, M and M Schneider (2006.), “Inflation and the Redistribution of Nominal Wealth,” Journal of Political Economy 114(6): 1069-1097.

Spitznagel, M (2012), “How the Fed Favors the 1%,” Wall Street Journal, 20 April.