Side effects of monetary policy are increasing

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During the past decades, there has been a trend towards increasing (income) inequality, which was somewhat mitigated by redistribution via government transfers. Various causes are cited in the economic debate, amongst which technological progress, which has benefited the productivity and hence the wages of the higher educated more than those of the less educated, is one. In addition, the relative decline in prices of capital goods accelerated the substitution of lower-skilled labour by capital (automation), while globalisation facilitated the international reallocation of economic activity. During the pandemic, the vulnerability of international production chains again came under scrutiny, leading to a tentative trend towards near-shoring. However, the extent to which this trend will continue and have a lasting impact on relative wages in the labour market is still uncertain. 

Increased income inequality is one of the factors cited as a plausible cause of the decline in the so-called real equilibrium interest rate (see also KBC Economic Opinion of 22 October 2021). That is the real interest rate that balances planned savings and investment in an economy. To the extent that the savings rate is higher in higher income categories than in lower income categories, increasing income inequality leads to a higher aggregate savings rate with downward pressure on the real equilibrium interest rate. This lower neutral interest rate level limits the scope for a stimulating interest rate policy on the part of central banks, which must therefore resort to non-conventional policy measures.   

Vicious cycle

The question is, however, whether central banks are only affected by the declining equilibrium interest rate as an exogenous factor or whether their policy, as an unintended side effect, also contributes itself to greater (income) inequality and thus to a lower equilibrium interest rate. In that case, monetary policy would have entered a vicious cycle. In that debate, central banks usually refer to the aforementioned ‘exogenous’ factors as the main cause of rising inequality (Dossche et al. (ECB, 2021)). Monetary policy, after all, has little influence on these trends.

By its nature, monetary policy always has a redistributive effect. This was also the case in the period preceding the financial crisis and the start of large-scale non-conventional policy measures. In the ‘conventional’ policy framework, the ECB was able to set short-term money market rates fairly precisely via the rate it charged on its regular refinancing operations. this was possible because in that ‘conventional’ policy framework there were no, or hardly any, ‘excess-liquidities’ (i.e. more than required by the regulator) in the money market. But even in such a framework, an increase or decrease in short-term interest rates inevitably also had a redistributive income effect. Net savers benefited from higher money market rates, while net debtors lost out. However, this redistributive impact was mostly limited, temporary and symmetric in nature. Indeed, in a conventional policy framework, the central bank will raise and lower its policy rate over the cycle, offsetting the redistributive effects over time. After the financial crisis, this was no longer the case. Policy interest rates in most major economies quickly approached their effective lower bound, with the associated redistributive effect from net savers to borrowers. In addition, large-scale non-standard financial asset purchase programmes emerged. These programmes provided an additional channel through which inequality is affected if we also take account of capital gains on assets. 

Impact on income and wealth inequality 

In the debate about the impact of monetary policy on inequality, we need to distinguish between income inequality and wealth inequality. It is a controversial debate without consensus (Ilzetzki (2021)). Regarding the impact on income distribution, most central banks argue that strongly accommodative monetary policy has reduced income inequality (Schnabel (ECB, 2021), Lenza et al. (ECB, 2018), Bundesbank (Monthly Report September 2016)). However, there are also studies that come to the opposite conclusion (Andersen (2020)). The ECB argument compares the actual evolution of inequality with what would have happened if monetary policy had not intervened. That alternative scenario (called the counter-factual) is estimated from a macroeconomic model. According to this comparison, monetary policy mainly benefited the lower income categories, for whom the unemployment rate rose much less during the crisis moments than it would have done in the alternative model scenario. 

From a theoretical point of view, this comparison is correct, and it highlights that during the financial and pandemic crises there was no plausible policy alternative. From a practical point of view, however, these model estimates are highly dependent on the model specification chosen. For example, the employment effect cited abstracts from the losses that net savers from low-income categories suffer on their savings due to negative real interest rates. Moreover, model estimates always have a large margin of uncertainty, so that the net effect of all effects together is uncertain. We should therefore interpret analyses and policy recommendations based on such alternative model scenarios with caution.

There is less disagreement about the impact of monetary policy on wealth distribution. This effect is also described in research reports of various central banks. The wealth effect is mainly caused by the non-conventional purchase programmes of financial assets by central banks. The direct impact is an increase in asset prices, which in turn mainly benefits wealthier households. As the risk-free (bond) rate also falls due to these purchases, there is an additional indirect effect whereby investors look for yield on alternative, riskier assets. The sharp rise in property prices is partly a reflection. In countries where home ownership is not evenly distributed, this leads to increasing wealth inequality (Schnabel (ECB, 2021)).      

This debate should be seen in the broader context of increasing side effects and diminishing benefits of the current non-conventional monetary policy. In summary, it seems that there are indeed side effects on the distribution of income and wealth, which are admittedly difficult to measure precisely. If this hypothesis is correct, the implications should not be underestimated. Monetary policy would then in fact be reducing its own conventional policy margin by causing the equilibrium interest rate to fall as well, thereby ending up in a vicious cycle. A possible way out would be to wind down the purchase programmes and return to a more conventional policy framework as soon as the current pandemic crisis recedes.