How monetary policy impacts income inequality is highly debated. Historically, income inequality has not been a primary concern for the Federal Reserve, who determines monetary policy, however, rising inequality is raising questions about the collateral effects of monetary policy. Ultimately, drawing more attention to the Federal Reserve’s role in addressing income inequality.

Historical Trends

The Federal Reserve was founded in 1914. In the book, "Central Banking Systems Compared: The ECB, The Pre-Euro Bundesbank and the Federal Reserve System", author Emmanuel Apel writes that the Federal Reserve's primary mandate was:" To provide reserves to accommodate routine variations in the need for credit to finance trade so as to avoid financial panics." After the Great Depression and the Second World War, the Fed's primary focus shifted towards economic stabilization. As inflation continued to rise into the 1970s and early 1980s, the policy makers turned their focus more towards price stability. The inflation rate remained relatively stable through the mid-1980s and 1990s. The Fed aims to sustain economic growth and price stability. In short, its role is to help ensure the financial system runs efficiently.

Since 2007, monetary policy in the United States has been widely unconventional. The Federal Reserve’s sweeping quantitative easing program inserted an incredible influx of capital into the markets to help stimulate the economy and increase liquidity into the financial system. It has had some effects that we will explore further.(For more, see: Does Quantitative Easing Work?)

 Unconventional Monetary Policy

Since 2008, unconventional monetary policies have taken the strides to help bolster the economy and improve the labor market. In a report to Congress in July, Federal Reserve Chair Janet Yellen stated that unemployment has decreased to 5.3%, down from 10% in 2009 and that the economy is continuing to make slow progress. Despite this progress, income inequality has continued to increase at sharper levels since the economic crash in 2008.

The National Bureau of Economic Research (NBER) lists the channels of accommodative policies that impact wealth, income and consumption inequality. These channels include the ‘income composition channel’, which posits that if expansionary monetary policy increases profits to a higher level than earnings, it may lead to greater inequality. With the majority of Americans earning their income from earnings and wages, more pronounced growth in income from profits of ownership of firms or business would raise this gap disproportionately. Also, owners of firms tend to be in a higher income bracket. A second channel is the ‘financial segmentation channel’, which suggests that individuals who are highly connected to markets would be more affected by the money supply and consequently acquire greater income through these transactions. This in turn, leads to a consumption inequality that favors those more connected to the markets.

Why is this important? According to the Survey of Consumer Finances, the top 5% wealthiest Americans own two-thirds of stocks, bonds, mutual funds and private pensions. One-third is owned by the next 45% highest earners and the bottom half of American’s own 2% of these assets. With the flood of capital into the market pushing yields on safer securities down, such as bonds, it has influenced the price of riskier securities to rise significantly.

James Bullard, president of the Federal Reserve Bank of St Louis, claims that the Federal Reserve's program of quantitative easing did not widen the inequality gap through the increasing the profits and prices of equities. He claims there is little difference in wealth distribution before the crisis. He claims it is, "only as good or as bad as it was before the crisis." (For more, see: Understanding Income Inequality.)

 Unequal Credit

In a speech on income inequality, Federal Reserve Chair Janet Yellen stated that ownership of a private business is one of four primary components of economic growth. Research conducted at the London School of Economics has shown that enacting policy that helps businesses access financing and loans may serve as a “positive growths multiplier” to the economy. Post-2007, the amount of capital available for small businesses, core components to revitalizing the economy, has been sharply reduced. If this continues, it could cause further strain on business and stymie growth. The Survey of Consumer Finances shows that owning a private business is an important economic opportunity. Economic mobility is linked to private business ownership, and over the past 30 years, the business creation rate has slowed considerably. (For more, see: Why Entrepreneurs Are Important for the Economy.)

Perhaps the lending practices that have followed the onset of the recession have compounded this effect. An article in the Harvard Business Review states that, contrary to popular opinion, the banks have in fact increased large business loans (loans over $1 million) by 23% since 2007. Small business loans (under $1 million)  have contracted by 14% since that time. Providing the means for small businesses to flourish matters. 65% of net job creation has taken place in the small business sector. Small business creates two-thirds of all new jobs.

Monetary Policy vs. Financial Policy

Fiscal policy can be used to achieve growth and reduce income inequality. Mark Carney, Governor of the Bank of England and the chair of the Financial Stability Board states, "If we want to talk about ultimate sources of growth, sustainable fiscal policy is a necessary condition. Sustainable growth comes from the private sector, not from the (International Monetary Fund), the Bank of Canada or anyone else." As a proponent of regulation, he stated governments need to revise how they respond to financial crises. Carney suggests re-framing the regulations to promote financial soundness in political policy decision making.

As banks continue to grow larger and the existence of smaller community banks diminishing, there may be a greater need for regulation. Here are two examples of the effects of a laxity in regulation: In the late-1990s the Fed allowed banks to decrease their capital by buying Credit Default Swaps (CDS) which in turn, were not overseen by the Fed. Secondly, despite the irrefutable evidence, the Fed failed to acknowledge the widespread risk inherent in the mortgage markets in the 2000s leading up to the financial crises.

With the introduction of the Dodd-Frank Act, the Federal Reserve has tightened capital requirements for banks and have systematically been pointing out riskier participants in the market. (For more, see Dodd-Frank's Consequences.) The supervisory role of the Fed has been reassessed and is currently working to prevent any oversight in its regulation of banks and the industry.

 The Bottom Line

The fine balance that the Federal Reserve has operated with its monetary policy has been beneficial overall to Americans over its history. More recently, the Federal Reserve has addressed factors relating to income inequality and creating reforms to prevent economic turbulence. There may be more room in both monetary and fiscal policy to address income disparity at length to attain sustainable growth.

 

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