By Karen Petrou
On March 12, the Financial Times ran one of Martin Wolf’s insightful columns, this one focusing on a critical facet of post-crisis monetary policy – ultra-low interest rates – to see why so much monetary-policy firepower had had such minimal macroeconomic impact. Mr. Wolf suspects that the secular stagnation first framed by Lawrence Summers means that ultra-low real rates are here to stay due in part to economic inequality. However, what if ultra-low rates on their own exacerbate inequality and thus create a negative feedback loop with dangerous implications not only for long-term growth and financial stability, but also for inequality? Considerable evidence shows that ultra-low rates are inextricably intertwined with extra-high inequality. Fed thinking on the new neutral rate thus must prick the traditional neo-Keynesian bubble to ensure that Chairman Powell’s new normalization isn’t a path to still worse inequality.
The Traditional Perspective
Traditional neo-Keynesian thinking has yet to accept the secular-stagnation construct or the balance-sheet recession hypothesis variation on this theme. But, even if the Fed moves on to recognize this new paradigm, there are still two reasons not addressed in secular-stagnation analysis that, the lower the interest rates, the worse the inequality and then, the worse the inequality, the lower the rates. Traditional neo-Keynesian and secular-stagnation theory neglect the impact of negative rates on small savers and assume that low interest rates enhance equality due to increasingly affordable debt. Low-rate corporate debt is also supposed to spur productivity and thereby boost employment. All of this would be to the good of equality, but only had any of it happened.
Ultra-Low Rates and Wealth Inequality
When interest rates are ultra-low, wealthy households with asset managers acting on their behalf can play the stock market to beat zero or even negative returns. We’ve shown in several recent blog posts how wide the wealth inequality gap is and how disparate wealth sources help to make it so. However, even where low-and-moderate income households can get into the market, their investment advisers should not and often cannot chase yields. As a result, ultra-low rates mean negligible or even negative return.
Historically, pension funds and insurance companies have invested only in the safest assets. These are now in scarce supply due in large part to QE and comparable programs by central banks around the world. Pension plans and life-insurance companies increasingly have two terrible choices: to play it safe and become increasingly unable to honor benefit obligations or to make big bets and hope for the best. Under-funded pension plans are so great a concern in the U.S. that the agency established to protect pensioners from this risk, the Pension Benefit Guaranty Corporation, faces its own financial challenges. Yield-chasing life insurers are also a prime source of potential systemic risk.
The importance of these programs and products to economic equality is evident not only in volumes of research about the need for retirement savings, but even in the actions of Americans in the post-crisis period. Despite all of the pressures on moderate-income households during the crisis and the recession in its wake, households are putting away what they can to protect themselves and their families. The “precautionary” savings balances of moderate-income households have slightly increased since the crisis even though their savings dwindle to less and less under the ultra-low rates small savers are able to earn in interest from a bank or similarly-secure institution.
As a result, and in sharp contrast to the rapid rise in valuation and return on the financial assets wealthy households own, savings accounts now are only a bit of insulation against unexpected expenses, not a wealth-accumulation engine. One recent study estimated a total loss across the U.S. economy of $2.3 trillion in savings-accounts and similar balances due to the very low interest rates that prevailed from 2008 through 2016.
Further, ultra-low rates do not have offsetting equality benefit due to lots of low-cost loans with which lower-income families might fund wealth accumulation and small businesses can fire up the income engine. A study of over a hundred global banks found that reductions in short-term rates are less effective as growth stimulants when interest rates are ultra-low, even after controlling for the changes in loan demand occurring after a financial crisis and differences among the banks surveyed. A study by Federal Reserve Bank of New York staff narrows this question to the U.S., also finding that lending drops as rates approach the zero lower bound (ZLB) because banks simply can’t make money making ultra-low interest rate loans. This same study also finds that banks adjusted to persistent low rates by changing their asset/liability mix away from deposit-taking and longer-term lending to less costly funding sources and short-term, interest-bearing investments such as excess reserves held at the Federal Reserve. As a result, the mix of monetary policy, regulatory requirements, and business-reality factors leads banks in an ultra-low rate environment to reduce lending, especially for the longer-term, lower-cost loans critical to wealth accumulation.
But, wasn’t there a burst of lower-rate mortgage refinancings that allowed households to reduce their debt burden and thus accumulate wealth? Did low rates allow higher-risk households at least to reduce their mortgage debt through refinancings? Again, low-and-moderate income households were left behind. They continued to seek refis after the financial crisis ebbed, but subprime borrowers current on their loans regardless of loan-to-value (LTV) ratios were less likely than prime or super-prime borrowers to receive refi loans even though higher-scored borrowers may or may not have been current and lower rates enhance repayment potential.
What about Income Inequality?
Clearly, the low interest rates that characterize secular stagnation are not only caused by inequality, but also cause it with regard to wealth accumulation. Worse still, ultra-low rates exacerbate income inequality, hollowing out opportunities for inter-generational mobility from start to finish.
A new research paper shows that low interest rates also exacerbate income inequality due to their direct and adverse impact on competition and, as a result, productivity.
This study combines what it calls a traditional macroeconomic effect – i.e., lower rates mean more productivity – with a strategic effect – i.e., what firms actually do as rates fall to ultra-low levels. This study uses theoretical models and empirical data to show that productivity rises as interest rates fall, but only to a point. When rates start to approach the ZLB, then productivity drops because market concentration increases due to lower expansion costs and pre-existing market power at the largest firms.
A brand new paper from the Federal Reserve Bank of Philadelphia buttresses this argument with its own data and model. These build out the strategic rationale powering up big companies during low-rate periods, showing that large firms operate at higher leverage than smaller or more monoline ones, leading to increased concentration and lower productivity as big companies muscle out a declining number of start-ups.
The obvious rebuttal to this productivity and concentration argument is that unemployment seems low. However, as we’ve shown before, wage growth is negligible in real terms and labor-participation rates remain, at best problematic. If ultra-low rates spark concentration, could it be that this concentration suppresses wages and concentrates employment at the top of the skill level? Nobel Prize winner Joseph Stiglitz has hypothesized that giant firms concentrate so much economic power that they set wages and otherwise control pricing and production across the economy to disadvantage low-and-moderate income households.
What do all these studies tell us about ultra-low rates and economic equality?
The income-inequality nexus to ultra-low rates is less clear than the damaging wealth-inequality impact. Still, there’s more than enough here to warrant a very hard look at the extent to which any fed policy premised on continuing low rates will make inequality even worse and the nation still more rancorous. The Fed plans to study post-crisis monetary policy, but it’s failed to put economic equality into the equation. Clearly, it’s past time to do so.