About the author: Karen Petrou is managing partner at Federal Financial Analytics and the author of Engine of Inequality: The Fed and the Future of Wealth in America.
The day Jerome Powell won his second term as Federal Reserve chair, he said he couldn’t promise a soft landing and hadn’t meant to commit his fellow policy makers only to fifty basis-point hikes. He has also walked away from his insistence that inflation is transitory and the economy is “robust.” We’ve gone from whatever-it-takes monetary policy to anything we can think of.
One major reason for this muddle is that the Fed’s models and objectives depend on anachronistic assumptions that America has a vibrant middle class. once we did; now we don’t. With a deep middle class, policy transmits effectively through the economy; without one, it can’t. We urgently need a new approach to central banking that takes inequality fully into account and thus protects sustained, shared prosperity.
Fed policy is ineffective because it is largely premised on two transmission channels blocked by economic inequality. First, the Fed expects ultra-low rates to spur households to borrow. But this channel doesn’t work because most American households are deeply in high-cost debt to handle day-to-day consumption. The bottom 50% of US households now have debt equal to 162% of durable assets such as automobiles and furniture. Inequality mires households in debt that is unresponsive to monetary policy except when rates go up and many families only get still more highly leveraged with debt that eviscerates opportunity instead of spurring growth. Ultra-low rates—and rates are still ultra-low despite Fed hikes after taking inflation into account—do encourage some borrowing, but the bulk of this is by older households that already own a home. This spurs housing-price bubbles that do nothing for lower-income households even as they increase financial-crisis risk.
Second, the combination of an economy in which the majority of households have little to spare and a financial market that—thanks in large part to the Fed—has long believed nothing can go wrong is a recipe for financial crises that sets equality even farther back . This dynamic makes recessions longer and deeper, and ensures that Americans grow be even angrier. More equal economies might prosper in tandem with their financial markets, but this requires more than a small minority of households to do well as markets rise. In the US, they don’t. The top 1% now owns 54% of US equities and thus gets a lot richer a lot faster even though their consumption largely fuels asset-price bubbles, not shared, stable growth.
Fixing what’s broken in Fed policy making starts with meaningful data and useful models. To know what it’s doing, a central bank must base its conclusions about growth on “distributional” indicators, in other words, those that reflect actual income and wealth holdings for different households and the economic power they wield. These indicators convey how households are likely to behave under different interest rates, Fed-portfolio levels, and economic or financial stress. These data and models cannot rely on aggregate GDP and should judge employment by looking at labor force participation and inflation-adjusted wages and understand price stability through the lens of what it really costs the majority of households to make ends meet.
In addition to models that ignore inequality, the Fed relies on the Beige Book, a regular survey of economic conditions in each Federal Reserve district. Consistent with its top-down focus, the Fed’s Beige Book surveys bankers and business executives, not households. These insights are of course important, but they form only one part of the macroeconomic picture. The rest is distorted unless the Fed considers the necessary corrections equality-focused data would provide.
The Fed actually has a lot of these data. For example, its triennial Survey of Consumer Finances and its new, fast-acting Distributional Financial Accounts give the Fed good data. All that’s needed is for the Fed quickly to put them to use.
The next step for the Fed is to make interventions that backstop shared prosperity, not financial-market profitability. A new economic-equality assessment from the central bank of central banks reaches a valuable conclusion: Fiscal and monetary stimulus proved ineffective as income and wealth inequality grew ever worse. The Bank for International Settlements research thus recommends “automatic stabilizers,” economic or financial-market guardrails that pop up as soon as real-time data show significant risk of a severe downturn or market crisis.
It would be relatively simple to craft monetary-policy automatic stabilizers in the US The Federal Reserve already has discretion to intervene when it finds “exigent or unusual circumstances.” Current law also gives the Fed authority to impose a counter-cyclical capital buffer on banks. The Financial Stability Oversight Council can craft similarly counter-cyclical standards more broadly across the entire financial system.
The Fed could, for instance, create a liquidity facility to support short-term, small-dollar lending when crisis strikes. Families suddenly thrown out of work would get the same breather to reorganize their liquidity the Fed has long granted the financial market. To ensure these facilities are automatic stabilizers, the Fed in good times would set rules binding itself to trigger these interventions when defined crisis conditions occur.
With inflation rising, the majority of Americans struggling, and financial markets wobbling, the absence of effective monetary policy to enhance equality is a dangerous vulnerability. It took fifty years for the US to experience a financial crisis after the Great Depression. Now, they seem as common as the thousand-year floods climate change makes increasingly routine. The longer bad policy persists, the greater the danger. If the Fed won’t fix itself, Congress should demand more of it.
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