Has Fed policy made inequality worse?

Income inequality has been one of the most-discussed economic topics in recent months, and in those discussions a topic that often comes up is Federal Reserve policy to combat the Great Recession. What impact has it had on inequality? Specifically, did quantitative easing (QE) and the Fed's low interest rates -- known as loose monetary policy -- benefit those at the top of the income distribution the most?

Many people seem to be convinced that Fed policy during the Great Recession did indeed make inequality worse. Among them are Ron Paul and the so-called Austrian economists, as well as many others on both sides of the political fence. Are they correct to claim that loosening monetary policy to combat recessions makes inequality worse?

Economists Olivier Coibion, Yuriy Gorodnichenko, Lorenz Kueng and John Silvia examine this issue in a working paper from the National Bureau of Economic Research (described by the authors in a nice, nontechnical summary at Vox EU). Using detailed data on consumption and income from various sources, the research documents the channels through which monetary policy can affect inequality.

They find that in the U.S. between 1980 and 2008, contractionary monetary policy actions tended to raise economic inequality or, equivalently, expansionary monetary policy aimed at fighting recessions lowered economic inequality. Thus, the empirical evidence indicates monetary policy actions affect inequality opposite to the manner suggested by Ron Paul and the Austrian economists.

The data do not allow for a detailed examination of each and every potential channel through which monetary policy can affect inequality. But the total effect can be assessed, and two effects in particular can explain much of the change in inequality.

The first is a difference in how labor income responds to a monetary policy shock. Loosening monetary policy tends to lower the labor income of those at the top of the income distribution, while increasing labor income for those at the lower end (partly by increasing employment).

Second, monetary policy has different effects on borrowers and lenders. Unexpected interest rate decreases tend to hurt those who lend money (who are generally at the top of the income distribution) and help those who borrow for houses, student loans, etc. (borrowers tend to have lower incomes).

Thus, when the Fed lowers interest rates, it tends to help those at the bottom of the income distribution and hurt those at the top.

The authors identified an additional notable effect, and that's how government transfers of income, which rise during recessions and fall during recoveries, affect inequality.

The research finds that "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."

Finally, the authors note that being stuck at the "zero lower bound" -- the Fed's inability to lower interest rates further -- is equivalent to a series of negative monetary policy shocks, the type that make inequality worse. Thus, the costs of being stuck at the zero lower bound, as we have been for some time now, may be much larger than previously thought.

The results in the paper are quite robust and quite important. Those who dislike the Fed's policy for a variety of reasons, e.g. too much government involvement in the economy, the so far unfounded fear that QE would debase currency, that QE only serves financial interests and so on, have tried to block or limit the Fed's policy reactions using the argument that fighting recessions with monetary policy makes inequality worse.

The results of this research, along with the fact that the impact of the Fed's loosening of policy to fight a recession will be largely reversed when it tightens during the recovery, should help to put those arguments to rest.