The FED Does Make Inequality Worse But Not the Way You've Been Told
A recent New York Times OpED written by a Federalist Society employee claimed that by keeping interest rates low, the FED is increasing inequality. This is part of an ongoing trend of rich Wall Street tycoons and conservative activists attributing inequality to the FED.
In fact, the FED has no control over the long-term level of interest rates and cannot really be held responsible even if they are too low. Furthermore, lower interest rates mean lower inequality. After all, rich people stay rich (and get richer) because the rates of returns on their loans and investments are high.
The truth is, high inequality is a reason interest rates are low, not the other way around. The government does exercise discretion on how to lower interest rates. It could have lent money to ordinary people rather than corporations in 2008 and 2020, so interest rate policy does have some impact on inequality. However, in general, the claim that low interest rates create inequality is actually used to obscure the fact that redistribution, not a new monetary policy, is needed to make a better society.
Rich People and Conservative Activists Say Low Interest Rates Increase Inequality:
PBS recently ran a documentary called Power of the FED. That documentary included an interview of a former FED official who later served in the Bush administration. That official complained about the inequality created by low interest rates. At the same time, the documentary included an interview of a current FED official and Democrat, Neal Kashkari, who said most of the complaints about low-interest rate induced inequality were actually coming from Wall Street.
I have to agree with him. For instance, Mohammed El-Erian, a Wall Street investment banker, is repeatedly invited on TV programmes for CNBC, For Business and Yahoo Finance to argue against low interest rates for a variety of reasons, one of which is that it makes inequality worse.
The FED Cannot Control The Long-Term Level of Interest Rates:
Monetary policy is about finding the sustainable long-term level of interest rates, not setting it. The FED cannot push interest rates too low or too high in the long run without destabilizing inflation, and they should not be blamed or credited for the level of interest rates in the long run.
The level of inflation is determined largely by the expected level of inflation and by the strength of demand in the economy. When the demand for goods and services is high companies can raise prices higher than expected inflation and workers can bargain for better wages. When it is weak, prices decline less than expected inflation and labor costs (in terms of wages relative to labor productivity) decline lower than expected inflation. The graph below shows inflation and expected inflation and shows that inflation declines against expectations during normal recessions.
Ignoring the spike in actual inflation at the end of the chart, the most remarkable feature of the chart are the declines in inflation following the 2008 recession and 2001-2002 recession. The spike in inflation follows an unusual recession which was caused by a simultaneous decline in spending and in the economy’s productive capacity. It is possible the supply-side effects of COVID -19 are overpowering the demand-side effects, especially when fiscal and monetary policy are keeping spending from declining too much.
This relationship between the strength of demand in the economy (relative to supply) and the contrast between expected and actual inflation limits how low or high demand can be in the long run. Persistent undershoot or overshoots of expected inflation will destabilize inflation expectations.
There is therefore a limit on how much the FED can do to pump up the economy (or keep it weak). Hence low interest rates over the past decade do not indicate a preference by the FED. Instead, the past decade of inflation undershooting expectations indicate the FED has acted with a bias towards high interest rates which threaten to destabilize the economy in the direction of deflation. It is partially for this reason the FED has tried to be serene about recent high inflation.
In conclusion, the low level of interest rates we’ve experienced for the last decade is largely a result of factors outside of the FED’s control.
Low Interest Rates Reduce Inequality
There is a technically correct short-term argument one can make to say that lower interest rates increase inequality. That argument is that lower interest rates will push up asset values and mainly rich people own assets. However, this effect will be short-lived. Over the long term, lower interest rates will reduce inequality by encouraging investment and favoring borrowers over lenders.
The standard argument that low interest rates increase inequality is that they increase the value of assets like stocks, bonds and homes. Those assets belong to rich people, so the benefits are felt by the rich. This is a fair argument, but only over a short period of time.
When interest rates drop lower, this does raise the value of assets. This is because income in the future is worth more when interest rates are lower. For example an agreement for someone to pay you $104 in a year is worth $100 if the interest rate is 4% or $104 if the rate is 0%. However, a one-time drop in interest rates should not lead to permanent growth in the value of assets through this mechanism. Instead, a one-time drop in interest rates can only increase income for asset-owners one time while asset prices increase in value to price in lower interest rates. After that, there is no reason to believe that lower interest rates can create permanent price growth in assets.
A longer term effect will be more investment. When home prices are higher, when it is easier to raise money on the stock market and when the cost of getting a loan are lower, rich people and firms will be incentivized to invest and expand production in a way that undercuts each other’s profit margins.
Imagine for instance, housing prices go up relative to rent because of lower interest rates. In response, (because housing prices have also gone up relative to construction cost) more houses get built which could push prices down roughly to where they were beforehand. However, this time, rent prices are much lower. In the long term the real losers are the landlords and the winners are the tenants. Owners of other forms of capital (like stock-owners who indirectly own restaurants, factories, etc…) are effectively charging the rest of society rent in a similar fashion to a landlord, only it’s called “profit.” They will lose out similarly in a low-interest rate environment.
Additionally, with lower interest rates, borrowers of money (like the poor and the government) will pay less to lenders of money (the rich).
Rising Inequality Contributes to Declining Interest Rates
A lot of conservatives and Wall Street investors want you to believe that their incredible wealth is due to the FED distorting their economy. In reality, their wealth is the distortion and the FED has to manage around it by keeping interest rates low.
The long-term appropriate level of interest rates is influenced by factors which impact the strength of the demand. If demand gets stronger at any level of rates, then the level of rates with appropriately strong demand goes higher as well. Hence increasingly regressive taxes and increasingly unequal pre-tax income are pushing down the appropriate long-term level of interest rates. This is because wealthy prophets spend less money on the margins when given more income and wealth. The more that wealth is distributed to rich people, the weaker demand gets at a constant level of interest and the lower interest rates have to go to keep demand stable.
How The FED is Contributing to Inequality
Following the housing crash in 2006, the FED had to resort to unconventional policies to lower interest rates. The level of interest rates had been declining previously and this long term;1 decline made it so that some interest rates got very close to 0%. For instance, the Federal Funds Rate, a very short-term interbank lending rate, dropped below .25% in 2008 and stayed that low for years. The FED didn’t like negative interest rates. What it did was accept deposits and short term loans from financial institutions at slight, positive rates. This has kept short-term interest rates from going negative. What the FED did to keep overall rates low was called “unconventional monetary policy.”
The largest component of unconventional monetary policy is “Quantitative Easing” (QE). QE constitutes purchases of long term loans either to the government or insured by the government. The argument that this increases inequality is the same bad argument I already responded to. It may be the case that the FED should borrow less (or more) in short term loans in order to borrow less (or more) in long term loans because this could reduce inequality. In reality this is a very complicated and technocratic argument which I think has no conclusive answer yet.
The other part of unconventional monetary policy is emergency loans to corporations. The FED did a lot of this following the Great Recession of 2008 and following the COVID Recession of 2020. In both cases these moves were made possible by special emergency legislation (TARP in 2008 and the CARES act in 2020). In both cases this does increase inequality. In both cases some institutions owned by rich people got loans, but struggling poor people did not get loans. By lending to specific institutions, rather than buying government obligations, the FED directly transferred wealth to their chosen borrowers. These policies clearly reflected a wealth transfer because firms would not have borrowed from the FED unless the FED was offering better terms on the loans than those firms could have gotten from the market. If the FED lent money to poor people and only poor people, this would transfer wealth in a way which reduces inequality.
Hence, some FED actions which lower interest rates do increase inequality, but not because low interest rates drive inequality. Alternatively, there is a potential for FED actions which reduce interest rates to mitigate inequality.
Low Interest Rates Obfuscate the Real Drivers of Inequality
We all know what can reduce inequality. We should tax rich people more, poor people less and have the government spend money to provide higher quality services and guaranteed income to everyone. We also know that the people who whine the most about low interest rates don’t want that to happen. All the conservative activists that say low interest rates make inequality worse supported the Trump tax cuts. All their concern about low interest rates are either disingenuous acts of 3d chess or attempts to assuage their own guilt.
If one wants higher interest rates and/or lower inequality they should want a more progressive tax system, more government education spending, more favorable laws to organized labor and more government welfare spending. Those programs will work to reduce inequality while raising inflationary pressures which the FED will respond to with higher interest rates.