With the first 100 tumultuous days of the Trump administration behind us and the Federal Reserve Board considering monetary-policy tightening, it is clear that U.S. bankers face a very different policy framework than just a few months ago. What happens next will drive not only bank profitability, but also and, still more importantly, political stability.
This is because the next round of monetary- and regulatory-policy actions will have profound impact on whether the U.S. income and wealth gap grows even wider between rich and poor. Our new research demonstrates that regulatory and monetary policymakers must consider economic equality as they contemplate realigning the pillars of U.S. financial policy. If they don’t, then the economy won’t grow in a sustainable way and political discontent will get still worse.
Financial policy and economic equality
The Fed is deeply worried as the U.S. economy grows ever more unequal, but it also blames widening income and wealth distributions on everyone else. It is true that demographics play a role, as do embedded economic-mobility challenges for racial and ethnic groups, and Americans living in less-affluent communities. However, at its root, economic equality is, as its name suggests, an economic phenomenon. As a result, the Fed has an important role in either improving or worsening the situation.
Look, for example, at what just one economic policy under the Fed’s control — ultra-low interest rates — has done to economic inequality. By one account, savers since the crisis have lost $2.23 trillion due to Fed-set rates. Ultra-low rates — still negative in real terms once inflation is considered — strip savers of the wealth they need to pursue life objectives such as education or buying a home or ensuring retirement security. Changes to fiscal policy won’t make up for such a loss, and Americans who suffered can’t quickly regain the economic footing they need to pursue life objectives.
The Fed’s broad power over regulatory and monetary policy gives it tremendous sway over the engines of economic equality — power it should use quickly, where it can, to reduce growing concentrations of wealth and income in an ever-smaller percentage of the U.S. population. The Fed is uniquely positioned to make a major difference in narrowing the gap because of its role not only as a central bank, but also as a major financial regulator. For example, its $4.5 trillion portfolio has been shown by extensive research to favor the financial assets owned by wealthier households, with lower-income Americans generally relying on their homes and savings accounts for wealth accumulation.
Although average home values have spiked since 2012, price appreciation in areas affordable for low- and moderate-income households lags far behind that in high-cost areas, with many borrowers actually still underwater on their mortgages. New regulations — particularly capital requirements and the Consumer Financial Protection Bureau’s mortgage underwriting standards — also diminish mortgage credit availability for the higher-risk borrowers who suffer under economic inequality.
Restrictions on lending resulting from new capital and liquidity rules also have an adverse effect on another lending category critical to economic equality: small businesses. Although some have suggested that credit availability is ample in this sector, our recent research and even a new Fed study show otherwise. Gross credit numbers say little about equality-oriented lending or about the role of banks in credit distribution. But drilling down into the numbers for these types of loans shows clearly that the Fed’s heavy hand influences the level of economic equality.
The adverse effects on economic equality might be warranted if the Fed could assure us that an overarching goal — financial stability — has been achieved. The last crisis showed all too clearly how enormously harmful financial instability is to the most vulnerable households. However, despite significant gains in bank resilience due to all the new rules, it is far from clear that financial markets are safer. Crises could in fact come from causes stoked by Fed policy, such as yield-chasing. Recent studies have also found that all the new bank-capital rules do not necessarily make banks any safer, with one suggesting that the rules in fact undermine financial stability. Although the Fed hopes its post-crisis macroprudential toolkit will steady financial markets, our research suggests this is unlikely because. Due in large part to all the new rules, finance is slipping out from under the Fed’s reach because of the growing role of nonbanks.
How the Fed can reverse adverse effects on economic equality
The economic-inequality effects described above are far from what the Fed intends. The central bank has long believed that its actions further equality by promoting maximum employment and price stability. However, almost 10 years after the crisis, employment is only full if one measures it in the most favorable light, and deflation is a bigger risk than inflation. Unprecedented levels of accommodative policy have barely pushed the recovery needle. Not all the reasons for secular stagnation and what I call a balance-sheet recession are the Fed’s fault, but enough of them are that the Fed should quickly remedy them.
How? First, by consciously and publicly considering the effects of monetary and regulatory policies on income and wealth distribution. In the past few weeks, there has been much discussion of when and how the Fed should let its balance sheet run off. This is a good discussion to have given how the Fed’s balance sheet drives economic inequality. However, all of the Fed’s discussions consider only how the portfolio would affect the yield curve and the Fed’s own powers, not how changing asset valuations affect wealth accumulation. Similarly, when the Fed considers interest rates, it does so only with an eye on its own considerations, not the impact of ultra-low rates on savers.
Regulatory analyses are similarly one-sided. The Fed looks at the effects on banks’ capital levels and liquidity, and how each regulatory standard meets a financial-stability objective. But none of these rules has been considered in the context of all of them. Such consideration would potentially shed light on how they affect Americans’ individual balance sheets. For example, the cost of capital has not fallen as the Fed expected when new rules were imposed, thereby exacerbating adverse credit-availability challenges. The Fed also has not connected the dots by considering how new rules intersect with monetary policy, and then how unintended consequences adversely affect economic equality. Global research has found many cumulative effects, but it too has not correlated those effects with the critical equality question.
It is past time to make economic equality part of the discussion. Economic factors have already changed the bank business model. Look, for example, at the dramatic shift away from traditional retail banking to wealth management. It is also no accident that the role of “shadow” banks has grown exponentially since the crisis, a result of both new rules and accommodative policy. Perhaps in time, nonbanks will replace banks as core providers of the financial services critical to economic equality. But this may pose a risk to financial stability. Even if the dominance of nonbanks poses no such risk, a benefit to economic equality may not come soon.
As a result, many Americans may well get poorer as a few get richer still. That is a recipe for political discontent that will make the 2016 election look only like a warmup act.