Long-Run Monetary Policy and Inequality

The following is a draft of my remarks from my meeting this afternoon with Philadelphia Federal Reserve President Patrick Harker and a group from Action United.

I appreciate and admire the Fed staff and officials who have done an excellent job in the very difficult economic environment of the past decade. I do not consider myself a highly political person, and as an academic, I am much more interested in trying to contribute to a better objective understanding of monetary policy than in involving myself in monetary politics. The idea of a politically independent Fed is so comforting to economists like me, within and outside of the Fed, who idealize technocratic merit and objective policymaking. But monetary policy has inescapable distributional implications, some real and some perceived, many of which are not fully understood in theory or empirically. And because monetary policy affects distribution, there are always going to be interest groups with a stake in the conduct of policy. The Fed cannot and need not hope to please every person all the time, but the democratic legitimacy of the institution requires that it make a real effort to understand the disparate impacts of its policies on different groups and to communicate with all segments of the public about the issues that concern them most.

So how does monetary policy affect inequality and the lives of low- to middle-income households? Since the employment, hours, and wages of low-to-middle-income workers are most sensitive to business cycle conditions, I think it is generally accepted that lower interest rates and higher employment reduce inequality in the short run.[1] Of course, monetary policy cannot be permanently expansionary; we can’t arrive at and stay permanently above full employment just by allowing slightly higher inflation. Economists who understand this distinction between the short-run and long-run Phillips Curve might then conclude that monetary policy has only cyclical effects on inequality.[2]

In the long-run, as John Taylor noted in 1979,[3] there is no long-run tradeoff between the level of output and the level of inflation, but, there is a tradeoff between output stability and inflation stability. If you think of the long-run monetary policy tradeoff as a production possibilities frontier showing different combinations of output and inflation stability that are possible, then the two big issues are (1) choosing which point on the frontier we want, in other words what relative value to place on output stability versus inflation stability, and (2) achieving a point on the frontier, rather than inside of it. These are the issues I use to frame my thinking on monetary policy and inequality, and I would like to talk about each of these issues for the next few minutes.

Regarding the first issue, Stephen G. Cecchetti and Michael Ehrmann show that since the rise of inflation targeting around the world in the 1990s, policymakers’ aversion to inflation volatility has risen in both inflation targeting and non-inflation targeting countries, with a resultant increase in output volatility.[4] In evaluating the relative emphasis to place on output stability versus inflation stability, it is worth trying to understand how this long-run tradeoff affects workers across the income distribution. If the relative harm of output volatility vs. inflation volatility is greater for low than for high-income households, than monetary policy could have lasting effects on inequality. This seems likely, given differences in savings and credit constraints that make it more difficult for lower-income households to smooth fluctuations in income. Output volatility could be especially harmful in the presence of scarring effects of unemployment, which mean that the harmful effects of downward fluctuations are not fully offset in upturns.

The long-run monetary policy tradeoff between output stability and inflation stability, may not only affect inequality, but also be affected by it. High inequality can impact the Federal Reserve’s ability to conduct monetary policy, for example through differences in interest rate sensitivity across the income distribution. This can worsen the sacrifice ratio, effectively moving the frontier inward.

Regarding the second issue, achieving some point on the frontier of output stability and inflation stability requires good credibility and also requires that monetary policy fully offset aggregate demand shocks, avoiding short-run errors.[5] Otherwise, both output volatility and inflation volatility will be unnecessarily high. Financial crises and the zero lower bound impede the ability to offset negative demand shocks, so preserving financial stability through regulatory and supervisory policy is especially important.

Offsetting fluctuations in aggregate demand is easier said than done, especially because monetary policy works with lags and because there are so many indicators to consider. Currently, the labor market shows signs that it is beginning to tighten. Even though inflation is below target, the FOMC chose to raise the federal funds rate, presumably to fend off any inflationary pressures that might begin to build. In considering the pace of future rate hikes, the Fed should keep in mind that the positive effects of a tighter labor market for reducing inequality are just beginning to appear. The unemployment rate for white men fell from 4.4 %to 4.2%.over the past year, and for black men fell from 11% to 8.7%,[6] so you can see the tighter labor market beginning to benefit African Americans, with plenty of room for further improvement.

Hourly pay grew 2.5% in 2015, compared to 1.8% in 2014. That is definitely an improvement, but it will take continued and stronger nominal wage growth to see the labor share of income regain lost ground and to get a real rise in living standards for the majority of households. Even as wages begin to rise more rapidly, I do not think that there should be too much concern that this will lead to strong inflationary pressures. Research by Federal Reserve Board economists Ekaterina Peneva and Jeremy Rudd, for example, points to a much weakened transmission from labor costs to price inflation.[7]

There are also several indications that labor markets still have room to tighten further. The number of persons employed part time for economic reasons hovers at 6 million, and the U-6 unemployment rate was unchanged at 9.9% in the latest jobs report. Labor force participation, at 62.6%, also has room to grow. Overall, to me it appears wise, given uncertainty about the global economy and inflation dynamics, to act cautiously, erring on the slow side for raising rates.[8]

[1] See, for example, Coibion, Olivier, Yuriy Gorodnichenko, Lorenz Kueng, and John Silvia. 2012. “Innocent Bystanders? Monetary Policy and Inequality in the U.S.” IMF Working Paper 199.

[2] . As Romer and Romer (1998) explain, “Because of the short-run cyclicality of poverty, some authors have concluded that compassionate monetary policy is loose or expansionary policy…[T]his view misses the crucial fact that the cyclical effects of monetary policy on unemployment are inherently temporary. Monetary policy can generate a temporary boom, and hence a temporary reduction in poverty. But, as unemployment returns to the natural rate, poverty rises again.”

[3] Taylor, John. 1979. “Estimation and Control of a Macroeconomic Model with Rational Expectations.” Econometrica 47(5): 1267-1286.

[4] Cecchetti, S. G. and Ehrmann, M. 2002. “Does Inflation Targeting Increase Output Volatility? An International Comparison of Policymakers' Preferences and Outcomes,” in N. Loayza and K. Schmidt-Hebbel (eds), Monetary Policy: Rules and Transmission Mechanisms, Proceedings of the 4th Annual Conference of the Central Bank of Chile, Santiago, Central Bank of Chile, pp. 247-274.

[5] See Cecchetti, Stephen. 1998. “Policy Rules and Targets: Framing the Central Banker’s Problem.” Economic Policy Review. Federal Reserve Bank of New York.

[6] BLS January 8, 2016 Employment Situation Summary

[7]Peneva, Ekaterina and Jeremy B. Rudd. 2015. "The Passthrough of Labor Costs to Price Inflation."

[8] See Brainard 1967 "Uncertainty and the Effectiveness of Policy," American Economic Review Papers and Proceedings 57(2); and Blinder, Alan. 1999. "Critical Issues for Modern Major Central Bankers."