Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients on the fed’s unintended impact on income inequality.
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: July 1, 2016
Fed’s Unintended Impact On Income Inequality
All too often, we only find out that we’re living on landfill when it collapses in an earthquake. We could know this if we looked – it’s not that hard to spot – but secure in our comfy couches, we don’t give it a thought until the dishes come out of the cupboards. So it is with Brexit, the Trump jihad, Bernie’s burn, and all of the other shake-ups of the comfy class from down below. Income inequality isn’t just a great topic for another Fed conference – it’s a critical social-welfare question that calls urgently upon every established power to take it very, very seriously, starting first with the Fed. The Fed has saved us from a 2008 disaster and made U.S. finance safer, but at great cost to wealth distribution that cannot stand uncorrected until rates “normalize” and the central bank goes back to basics.
Income inequality is a complex phenomenon spurred by many forces that often seem intractable to immediate action. Certainly, problems like huge gaps in social mobility spawned by profound educational-system failures are compounded by fiscal-policy shortfalls and general political dysfunction. But, agreeing that a problem is complex does not absolve one of trying to remedy aspects of it which fall within one’s own bailiwick. This brings me straight to the Fed.
In the wake of the 2008 crisis – and thank you again, Fed, for stepping in without your usual reserve – the U.S. central bank has instituted historic levels of accommodative monetary policy and a blistering set of new rules for U.S. banks. Many of the latter are mandated by Dodd-Frank, but most of what the Fed has done goes beyond what it must do and then some to craft a very stringent capital, liquidity, and prudential framework, especially for GSIBs.
This you of course know. What’s the link to income inequality? See below:
1) Due to massive quantitative easing, the FRB has altered asset pricing in an effort – so far only barely successful – to spur economic recovery. Had this worked fast, all would have been well, but the result of a prolonged, huge FRB portfolio is asset-price reallocation. This means a sharp rise in the valuations of the wealth-accumulating assets owned by higher-income households (e.g., stocks, bonds, and investment funds) versus housing –about the only wealth-accumulating asset accessible to low- and moderate-income individuals.
2) Accommodative monetary policy also drops interest rates to very low levels, making savings a losing game even as the wealthy are motivated to buy more financial assets to maximize yield wherever they can.
3) The combination of asset-price distortions and very low interest rates makes it very difficult for traditional providers of financial intermediation – that is, banks big and small – to reward depositors, make profitable loans, and earn a bit for the shareholders in the all-important net-interest margin. Add in costly new rules, and banks are essentially pushed into corners of the intermediation chain.
4) With banks under the blankets, non-banks that need not rely on NIM come out to fragment the financial-intermediation chain in a dizzying array of new payment, deposit-like, and lending products. Some of these are valuable innovations, some not; none has yet been tested under stress and many have significant public-policy and consumer-protection downsides. A particular concern here is alternative deposit products that undermine the ability of low-and moderate-income individuals to assemble the safe stores of funds vital to security and even better to prosperity — a prepaid card just isn’t the same as an FDIC-insured deposit even if the card is prettier.
5) Pockets of financial intermediation mean winners and losers across what was once the intermediation chain with a strong edge given to wealthier households because that’s where the money is. See, for example, the strategic shift of large banks into private wealth management to anticipate what capital optimization does to wealth distribution.
Fixing monetary-policy drivers of income inequality does not mean adopting the Taylor Rule – quite the contrary. Nor does it mean going below the zero lower bound as progressives often urge – that way lies melt-down of what’s left of the financial-intermediation chain and descent into a financial system in which current allocations favoring the wealthy look like public welfare. Nor does fixing financial intermediation so that traditional providers of proven products earn a profit mean revisiting the very, very bad old days of lax regulation and worse internal controls.
What is needed as a matter not only of economic, but also of political urgency is a clear understanding of what’s gone wrong in U.S. financial-market structure and why so much of it exacerbates income inequality. We can’t fix many of the most profound causes of social immobility or, worse, back-sliding, but some policies with adverse equality impact are near at hand and require urgent re-calibration.