It was my privilege to attend a recent conference at the Boston Federal Reserve on the topic of inequality — specifically, the growing inequality of opportunity in America. The presentations, including one by Fed Chair Janet Yellen, made a solid case that our high levels of inequality are eroding opportunity for many on the wrong side of the wealth divide. But there was a big question hanging over the proceedings: Can the Federal Reserve actually do much to reduce inequality or raise opportunity?
For at least three reasons, the answer is “yes.” Moreover, the Fed can also worsen inequality if it gets these wrong.
First, while it’s not the case that the Fed sets the unemployment rate wherever it wants, its macro-management function plays a substantial role in both the levels and changes in the jobless rate. By using its interest-rate tools to keep the cost of borrowing down and signaling to the investor community that it is committed to keeping rates low, it can help to trigger job-creating activity — from building a factory to renovating your bathroom.
To be clear, it can’t do this alone. Increasing the supply of low-cost credit doesn’t by itself create the demand to take advantage of it. But there’s little question that it helps. For example, analysis by Fed economists finds that its asset-buying program “…may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.”
Granted, this is a bit like asking your barber how your new haircut looks, but the Fed analysts use pretty standard methods to get these results.
Still, how do such improvements help with inequality and opportunity? By disproportionately increasing the pay of the least advantaged workers. The figure below shows the impact of a 10 percent decline in the unemployment rate on real wages for low-, middle-, high-wage workers. (BTW, that’s 10 percent, not 10 percentage points, so it means going from, for example, 6 percent to 5.4 percent.)
Lower unemployment helps low-end workers a lot, middle-wage workers somewhat less, and high-wage workers not at all. Directionally, that’s exactly the opposite effect of forces driving inequality.
A good example of these dynamics came in the latter half of the 1990s, when Alan Greenspan, to his great credit, allowed the unemployment rate to fall well below the rate that was thought at the time to be consistent with stable inflation. For the first time in decades, real low- and middle-wages grew at the rate of productivity, over 2 percent per year, poverty fell sharply, and real median family income grew by 13 percent between 1994 and 1999, its fastest five-year growth rate since inequality started rising in the mid-1970s.
To be sure, once you include financial assets that were appreciating quickly as the dot-com bubble inflated, the incomes of the wealthy were still rising faster than those of the middle class, so I’m not saying low unemployment wipes out inequality. But I am saying it helps to deactivate one of its most pernicious impacts: the channeling of income and wage growth away from the middle and bottom of the income distribution.
Speaking of financial bubbles, the second way the Fed can reduce inequality is through what it calls its “macro-prudential” function, i.e., financial market oversight. Over the Greenspan era, this function was largely assumed away under the ideological assumption that rational markets would self-monitor and self-correct. Whoops.
Bubbles and busts worsen inequality in two ways. First, the recession that follows the bust is disproportionately felt by the least advantaged. Look back at the figure above. The top-earning group may not get help from lower unemployment, but that means the group doesn’t get hurt much by it either. True, its assets take a hit when the bubble bursts, but the pattern in recent decades has been for the group to recover its losses well ahead of the rest.
Second, while lower unemployment pushes against inequality, American workers’ bargaining power is so low that it takes truly full employment to force employers to bid up pay to get and keep the workers they need. The current expansion is exhibit A of this dynamic: Unemployment has actually been falling pretty sharply, but real wages haven’t moved much yet.
Doesn’t this contradict the bars in the figure? To some extent it does, showing just how weak bargaining power is in the current labor market. But if you dig a little deeper into the dynamics behind that analysis, you find that it’s not enough for unemployment to be falling. It’s got to be low and stay low for a while.
In other words, for the least advantaged to benefit from an economic expansion, that expansion has to last long enough to reach and stay at full employment. The Fed’s oversight function is thus indispensable: it must become much more vigilant in breaking what I call the “shampoo cycle”: bubble, bust, repeat.
Finally, while much of what the Fed does is excessively scrutinized by the media and the markets, some of what it does in the inequality space is not known at all. For example, Eric Rosengren, the president of the Boston Fed, presented some really compelling work on a Fed-initiated project called the Working Cities Challenge, where Fed research and expertise combines with stakeholders in troubled communities to build human and investment capital targeted at low-income households.
The program is designed to diagnose and remove the barriers blocking upward mobility in communities where opportunity has been fading for years. As such, it pretty directly targets inequality. Taking myself as an example, I can assure you that even avid Fed watchers don’t know about initiatives such as this one.
Especially in the first two examples — macro-management and financial oversight — the Fed’s impact on inequality is symmetrical. The central bank can reduce it, as Greenspan did by allowing us to get to full employment, or exacerbate it (as Greenspan also did) by ignoring bubbles.
Right now, for example, there are many voices pushing Chair Yellen and Co. to tighten preemptively to stave off any future wage or price pressures. And as you can imagine, the finance sector isn’t exactly anxious to see the Fed ratchet up its oversight.
In both cases, it must resist. While lowering inequality is not directly part of the Fed’s mandate, it is in fact an outcome of its work, at least when it gets it right.