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How The Federal Reserve Quietly Worsens Inequality

The Federal Reserve is one of those institutions that everyone has heard of but no one really cares to talk about. Sure, you’ll have the odd conversation with your friend about rising interest rates and how that means something, probably, but are you really passionate about it? Do you get the same rush to open Twitter when Jerome Powell announces a rate hike as you do when Tucker Carlson interviews Putin and learns how shopping carts in grocery stores work? Probably not.

This is a problem. The Federal Reserve is by far the most influential economic institution in the United States. Yet, we generally do not recognize its major limitations as a one-tool organization. The most significant of these limitations is that relying on monetary policy for economic stimulus actually worsens inequality. 

To understand why delegating macroeconomic policymaking to the Fed is problematic, we need to understand why it came to exist, how it functions, and how it stimulates the economy. Following a number of financial panics in the late 19th and early 20th centuries, the Federal Reserve was established to help reduce the magnitude of similar future crises. The central banking system is led by a board of presidentially-appointed governors, operating independently of the bureaucratic sludge of the executive and legislative branches. And while the role of the organization has changed significantly over time—as economists and policymakers have collectively learned more about the field of macroeconomics—the fundamental mode of operation has remained the same. Since its inception, it has had a dual mandate: maximizing employment and maintaining stable prices.

The Fed accomplishes these goals by manipulating the Federal Funds Rate, a short-term interest rate that is used for interbank lending. For the most part, when the Fed adjusts this rate, all other short and long-term interest rates follow suit. When the country is in a recession and people are spending less due to high unemployment and low consumer confidence, lowering rates makes it easier for people to borrow, thus encouraging spending. Similarly, when the economy is overheating and inflation is rising, raising rates makes it harder to borrow, resulting in decreased spending. The Fed is in a constant seesaw between these two goals, balancing unemployment and inflation by way of the banking sector.

Given how limited are the Fed’s possible courses of action, it is odd that it dominates economic policymaking relative to fiscal policy. While fiscal policy is far more open-ended and more efficient at creating long-term stability, it has major drawbacks. Fiscal policy is economic policy created and implemented by the elected branches of the federal government, meaning a piece of such legislation must pass through both bodies of Congress and then the President, likely being debated and rewritten heavily at each step of the way. 

While the slow-moving wheel of the federal government is an obstacle to tackling all political issues, it is especially problematic in confronting economic crises. Recessions cannot be put off. When unemployment increases, poverty increases, suffering increases, and thousands of people die. So, when a bill to increase funding for food banks takes months to pass and be implemented, its effect as a recession reduction measure will be nullified. Therefore, for immediate impact, the Fed is far more effective. 

It is clear why the brunt of institutional economic response falls to the Federal Reserve, but not immediately obvious why that worsens inequality. To understand why, we need to look closer at how the Federal Reserve changes interest rates. They raise or lower interest rates through open market operations, in which they buy and sell securities (mostly bonds). When they buy bonds, they increase the amount of money in circulation by exchanging bonds for cash printed by the Fed. In turn, this increases the money supply, resulting in lower interest rates. In addition to the cash injection into the economy via bond purchases, lower rates mean a decrease in the cost of borrowing, encouraging individuals and businesses to take out loans and spend more.

Lowering rates also incentivizes bondholders to sell bonds since bond prices are inversely related to interest rates—raising rates decrease bond prices and vice versa. This means that during a recession, when the Fed lowers interest rates to encourage spending, that money first goes to bondholders who sold their bonds. Similarly, influencing interest rates has the same direction of effects on stocks, as stock price valuation is similarly discounted by interest rates. Therefore, stockholders likely also benefit when rates are lowered. These individuals benefit greatly from the Fed’s expansionary policy. They have a greater incentive to spend, which has a multiplier effect on the economy, helping increase total spending and ultimately GDP. 

Boosting spending sounds great in the aggregate, but the benefits must first flow through those who are able to buy bonds in the first place. To invest in any asset in the first place, one must have some level of savings that does not have to be spent on immediate survival. Someone living paycheck to paycheck is not investing in securities if they can barely invest in food and housing. And here lies the problem: when our economy goes into crisis, the people who face the hardest losses are those at the bottom of the socio-economic ladder. However, our most immediate course of action does not provide relief to those individuals. Rather it puts money in the hands of those likely to be less affected by recessions. 

The disproportionate flow of cash to the wealthy  has only worsened with the adoption of quantitative easing in the past twenty years. Similar to open market operations, quantitative easing (QE) is used to lower interest rates. But unlike open market operations, it entails the purchase of riskier stocks and other securities by the Federal Reserve. Compared to standard open market operations, quantitative easing directs monetary stimulus to an even narrower, richer section of the population than bondholders: individuals and firms with enough wealth to take risky investments. 

Riskier investments tend to only be made by richer people due to risk aversion—the level of apprehension an individual has towards risk. As an example, let’s imagine two choices: option A is a guaranteed $100; option B has a 50% chance of getting $500 and a 50% chance of losing $400. Even though these two choices have the same expected value, you would likely choose option A because Option B has much greater risk. While levels of risk aversion vary between individuals, they also vary based on wealth. People with greater levels of wealth are less risk averse as losses impact them relatively less. Someone with a million dollars is more comfortable with the risk of losing 200 dollars than someone who only has three hundred dollars. This disparity in risky investments makes quantitative easing a dangerous mode of stimulus. 

QE puts cash in the hands of massive firms and high-income individuals in times when low income people face the brunt of economic loss. This was especially true in 2008 when quantitative easing was introduced. Large banks such as J.P Morgan and Wells Fargo were heavily invested in mortgage backed securities, which are bonds backed by pools of mortgages. However, these bonds became increasingly backed by mortgages with a high risk of default. These subprime mortgages created a housing bubble which burst in 2008, causing many to lose their homes. Also as a result, banks began to suffer tremendous losses, failing to back up their deposits with liquid assets. The Federal Reserve stepped in and used quantitative easing to buy these toxic mortgage backed securities to prevent a vicious cycle of bank closures across the nation. 

In the aftermath, average Americans suffered while the bankers and financiers responsible for the crisis faced no monetary or legal repercussions. And while a wide range of recent research has supported the idea that quantitative easing did contribute to increased inequality, the Fed’s exacerbation of wealth disparities began well before 2008. Further, these disparities extend beyond income levels.

Historically, Black people have been cut out of financial markets for a myriad of reasons, from discriminatory policies that prevented the accumulation of economic resources in Black communities to racism within the financial services industry itself. So, as White people were able to take out loans and use those funds to invest in assets to build wealth, Black people were left behind. As the Federal Reserve utilized expansionary monetary policy during the various recessions of the 20th and 21st centuries, money flowed to those already able to buy bonds and stocks. Mainly, it flowed to White people, increasing their capital gains. Despite the civil rights gains for Black Americans from the end of slavery until now, the racial wealth gap still persists. It is driven mainly by capital gains and that initial difference in wealth, which led to a greater multiplication of wealth for white people. 

Monetary policy is not a scintillating topic. It is easy to get bored after hearing talk of bonds, interest rates, and quantitative easing. However, this is exactly what makes the Fed so dangerous. Boredom washes away scrutiny, creating a population that is unaware and uninterested, allowing our institutions to worsen the problems of the status quo. There is no simple solution to making people interested in the Federal Reserve, let alone tearing down and replacing the unequal foundation of our macroeconomy. But the one thing we need to agree on is that this system is flawed and needs a massive overhaul.

Featured image source: The Balance

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