The Fed’s heavy hand on economic equality

The US Federal Reserve insists it is exiting quantitative easing because the economy no longer needs the stimulus it provides. In reality, QE has benefited the haves at the expense of the have-nots and will be very hard to reverse, especially in light of post-crisis banking rules such as the liquidity coverage ratio (LCR), which make it challenging at best for the Fed to lower its asset portfolio to anything close to pre-crisis levels.

As the Fed reverts to a more conventional monetary policy, it must address the negative side-effects of QE and enact rule changes that encourage banks to lend and take deposits, rather than simply hoarding safe assets to meet regulatory ratios.

It is bad enough that a huge Fed balance sheet distorts asset pricing and allocation across the global economy, but from a social welfare and political stability perspective, it is still worse that QE has increased the already wide gap in US income and wealth equality.

The Fed’s QE defence – voiced by chairs Ben Bernanke, Janet Yellen and Jerome Powell in turn – is that post-crisis monetary policy was equalising because it prevented a Great Depression, and the Great Recession is transitioning to “full” employment, thus reversing the short-term income inequality effects.

Employment, though, is full only if you think that multiple wage-earners in a single family, each working multiple jobs, makes for prosperity despite the lack of meaningful wage growth in recent decades.

GDP is similarly robust if you average productivity gains across the population as a whole. Account for distributional effects and all too many Americans are stuck in seemingly endless recession. Aggregate totals tell us nothing about economic equality, which is clearly profound judged by any number of studies, calculations and analyses.

Critical microeconomic divides show even more clearly the adverse distributional effects of post-crisis monetary and regulatory policy. A scarcity of safe assets has sparked yield chasing and asset-price bubbles at considerable benefit – at least so far – to the richest among us.

Not only do new banking regulations redefine financial intermediation – especially in the US – but they also create a negative feedback loop with post-crisis monetary policy

An influential recent study from the Bank for International Settlements found the US has become sharply more economically divided, in part because financial asset valuations have risen faster as a result of QE than the value of savings and homes, which are critical to lower-income household wealth accumulation.                       

In the period immediately after the crisis, the asset-growth differential between the richest quintile and second-poorest quintile was between 4% and 8%. Even though housing started to function as an inequality decreasing force around 2012, stock returns have still grown at a faster rate, resulting in asset-growth differentials of generally around 2% during this period. Since then, the gap has widened because the market did better.

In the US, low- and moderate-income households hold their wealth (when they have any) very differently than the rich. The top 10% hold about half of their wealth in financial assets, such as stocks and bonds. Financial asset holdings dwindle as one gets below the 75% wealth threshold until one gets to the bottom 25% of the population, who have more debt than assets and rely on housing for the bulk of what they own.

This means ultra-low rates do grievous damage to those who can least afford it. They throttle macroeconomic growth because banks simply cannot earn a return by making loans. And they suppress the ability of lower-income households to get ahead by putting a little bit aside in a savings account or by contributing to a retirement plan.

Savings hit hard

As one might expect in a balance-sheet recession, households are putting away what they can to protect themselves and their families. Savings balances of moderate-income households have slightly increased since the crisis, but in sharp contrast to wealthy households that benefited from the rapid rise of financial assets, these savings accounts have been particularly hard hit by ultra-low rates. One recent study has estimated a total loss across the US economy of $2.4 trillion in savings accounts and similar balances.

All of this lost wealth puts the equality engine in reverse because it is extremely unlikely that a decade or more of lost savings can be recouped as millennials age and look to start households, fund their children’s education, and otherwise remain in or enter the middle class. Indeed, given the newly lower neutral rate and increasing inflation, saving will remain a losing game unless monetary policy is quickly and structurally realigned in concert with post-crisis regulatory changes and fiscal action.

Here is where monetary and regulatory policy intersect. Not only do new banking regulations redefine financial intermediation – especially in the US – but they also create a negative feedback loop with post-crisis monetary policy, accelerating and exacerbating other trends that widen income and wealth distribution.

This is not a call to “water down” the rules – some should be a lot tougher. I am particularly distressed by the slow progress of new rules to end too-big-to-fail financial institutions. Nothing would do more to restore market discipline and lighten the distorting role of financial policy than allowing financial markets to exact discipline and, if need be, vengeance.

Regulators have combined with monetary policymakers to define winners and losers in the financial sector – and, by extension, their customers and counterparties

In a recent speech, I outlined how the confluence of post-crisis regulations and monetary policy creates impediments to bank financial intermediation and affects economic equality adversely. When banks comply with the LCR by holding large balances of liquid assets this results in low rates and hinders the accumulation of wealth through saving. The enhanced supplementary leverage ratio further constrains saving because US banks must pay a high regulatory cost for the assets into which customer deposits are placed.

In this way, regulators have combined with monetary policymakers to define the winners and losers in the financial sector and, by extension, their customers and counterparties.

Don’t feel sorry for big banks? It is true that at least a good portion of these effects could be reversed for lower-income US households and small businesses if non-banks were to fill in the gaps in the US financial intermediation chain that open up as large US banks come under the post-crisis rules.

But without capital buffers to ensure continued credit under stress and given their dependence on market finance rather than stable deposits, non-banks are likely to prove procyclical if they take on a major role as US transaction account, payment service and credit origination providers. If this procyclicality is acute, income equality will be further harmed due to the damage done to financial stability and the resulting macroeconomic carnage.

The Fed is wrong

If rules matter for market stability – and if they don’t, what’s the point? – then we cannot solve the inequality effect of post-crisis policy by letting non-banks substitute for banks.

The Fed is wrong to dismiss the negative effects of its regulatory and monetary policies on economic equality.

“The degree of inequality we see today is primarily the result of deep structural changes in our economy that have taken place over many years,” former Fed chair Ben Bernanke said recently. “By comparison to the influence of these long-term factors, the effects of monetary policy on inequality are almost certainly modest and transient.”

Bernanke is right in that there was a lot of economic inequality before he took unprecedented action in 2008. However, both income and wealth inequality have worsened dramatically since 2010.

Sure, demographics make an equality difference, but did everyone get suddenly older in 2010? Is a shift in productivity or globalisation, or pretty much anything else, sudden and large enough to account for the sharp spike in both income and wealth inequality we have seen since 2010? The only thing with real economic equality impact that changed so much so fast in 2010, and thereafter, is monetary and regulatory policy, and we cannot ignore the correlation.

Karen Shaw Petrou is co-founder and managing partner of Federal Financial Analytics, a Washington, DC-based consultancy specialising in regulatory and policy issues affecting financial firms.