Monetary policy is not the solution to inequality

Should central banks do something about inequality and, if so, what? This has become a hot topic, which has persuaded the Bank for International Settlements to focus on it in its latest annual report. Its conclusions are what one would expect: monetary policy is neither the main cause of inequality nor a cure for it. Broadly speaking, this is correct. But in a world in which central bankers have become such aggressive actors, it may not be enough.

A striking fact noted by the BIS is that since what it calls the “Great Financial Crisis”, the proportion of speeches by central bankers mentioning inequality has soared. This partly reflects rising political concern about inequality. But it also reflects a specific critique. This is, in the report’s words, that “central banks have deployed policies featuring exceptionally low interest rates and extensive use of balance sheets to support economic activity and lower unemployment. Such measures have fuelled concerns that central banks’ actions, by boosting asset prices, have benefited mostly the rich”. That critique is popular among conservatives who detest activist central banks. (See charts.)

Yet there is also an opposite critique from people who upbraid central banks for not being activist enough. People in this camp argue that the failure has been to be too passive, letting inflation remain too low and labour markets stay too weak. At present, central banks, even the European Central Bank, are far closer to this position than to the more conservative one. Central banks, one might assert, have become more than a little “woke”.

This is an important debate, bearing on the legitimacy and consequences of what central banks are doing, especially in this era of crises. The view of the BIS itself is threefold. First, the rise in inequality since 1980 is “largely due to structural factors, well outside the reach of monetary policy, and is best addressed by fiscal and structural policies”. Second, by fulfilling their monetary mandates, central banks can reduce the impact of shorter-term shocks to economic welfare caused by inflation, financial crises and, no doubt, real shocks (such as pandemics). Finally, central banks can also do something about inequality with good prudential regulation, promoting financial development and inclusion and ensuring safe and effective payments.

Line chart of Stock and equity prices, average* of US, Japan, Germany, France & UK (Q1 2007 = 100) showing Asset prices have risen strongly since the global financial crisis

All this is sensible, so far as it goes. It is clear, for example, that falling real interest rates and easy monetary policies have tended to raise asset prices, to the benefit of the wealthiest. But, interestingly, the measured impact on wealth inequality has not been as dramatic as one might have expected. More important, it would have made no sense to adopt a deliberately more restrictive monetary policy solely in order to lower asset prices. This would have reduced activity and raised unemployment. That is the worst thing that could happen to people who are dependent on their wages for their livelihoods. Meanwhile, how would the majority of people, who own almost no assets, be better off because billionaires were a bit poorer? It would be mad for central banks to cause slumps in order to lower asset prices.

Line chart of Wealth inequality (% share held by top 10 per cent and 1 per cent of population) showing The limited evidence does not suggest soaring wealth inequality

A more relevant concern is raised by the dominant contemporary demand to “run the economy hot”. That raises two real (and possibly related) dangers: inflation and financial instability.

On the former, proponents of this approach argue that one cannot know where the risk of significant inflation lies without pushing the economy not just to, but beyond, the limit. But that could also prove costly if, as some fear, inflation soars and that overshoot proves very expensive to reverse.

Line chart of US employment by income level, % change since Jan 2020 showing The crisis hit poor workers far harder than rich ones

On the latter, it is hoped that sophisticated regulation will contain financial instability, even in the easiest imaginable monetary environment. That could be true, under ideal regulation. But regulation is never ideal. Moreover, it is already easy to identify vulnerabilities, notably in the non-bank financial sector. There is simply so much debt. That may be fine if interest rates stay low. But will they? Focusing on outcomes, not forecasts, makes this less likely.

Where the BIS is clearly correct is that fiscal and structural policies are the main way to address inequality. Indeed, some high-income countries are quite effective in using the former in this way. The big contrast between the US and other high-income countries in income inequality, for example, is in the relative absence of redistribution in the former. In some big emerging economies, there is little redistribution, especially in supposedly socialist China.

Dot plot comparing gini index for advanced and emerging economies

Structural policy is a still more complex issue. Too often, this is just a synonym for market liberalisation. But financial liberalisation has surely increased inequality and financial instability. So, good structural reform would almost certainly seek to constrain finance. Similarly, in labour markets with significant monopsonies, labour market deregulation might well be bad for employment and inequality. Moreover, rising inequality is almost certainly a factor in creating the structurally weak demand that explains the declining real interest rates and soaring indebtedness characteristic of our era of “secular stagnation”. For all these reasons, the structural reforms we should be thinking about are more difficult than conventional wisdom imagines.

The BIS is right that monetary policy cannot solve inequality. It can only aim at broad macroeconomic stability. Even that is hard to achieve, given our chronic reliance on expansionary monetary policy. In this context, financial excess is sure to re-emerge, making regulation an unending game of “whack a mole”. The BIS is correct to call for radical structural reforms. But they have to be the right kind of structural reforms.

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