Why income inequality could hamper the Fed

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Income inequality could be making Janet Yellen’s job even harder.

Rich Americans spend less of their paychecks than households of more modest means. As the top one percent accounts for an increasing share of the nation’s income, it may be reducing consumption, hurting growth and boosting savings. That could be contributing to rock-bottom interest rates that have left the Federal Reserve chair with little scope to ease in the next recession.

Take David Levine, a former chief economist at Sanford C. Bernstein & Co. who’s been a member of the one percent for decades. Levine says he’s “not living frugally” yet still spends only about a fifth of his income to maintain a very comfortable lifestyle on Manhattan’s affluent upper west side.

Contrast that with a middle-class American family. Those making between $70,000 and $80,000 spent about 78 percent of their incomes in 2014.

The debate about income inequality, and the general lack of wage growth for America’s middle class, is being amplified as a social issue by this year’s presidential race.

Now economists are taking a harder look at what it means for growth. By boosting savings and reducing overall demand in the economy, America’s large income divide could be one factor lowering the so-called neutral setting for interest rates, a theoretical concept that describes the interest rate that neither spurs nor slows growth.

The neutral rate matters for monetary policy makers: if it settles at a lower level, it means policy is able to provide less stimulus than in the past and officials have less room to support the economy by cutting rates the next time recession strikes. That would matter for everyone.

“There’s going to be a lot of interest in ways that we can increase that neutral rate,” said Gauti Eggertsson, a Brown University economist who is researching the topic. “If inequality is playing a role there, that might suggest fiscal policy has a role to play.”

Lower neutral

Eggertsson and his colleague Neil Mehrotra are trying to quantify how much inequality is weighing on interest rates. They expect to release their findings by early next year in a study that may be the first of its kind, though it builds on well-established theories.

Economists are almost positive that the neutral rate has fallen in the aftermath of the financial crisis. It’s hard to pin a precise number on the theoretical concept, but San Francisco Fed President John Williams and his co-author Thomas Laubach found in a recent paper that the rate in the U.S. probably fell to 0.4 percent adjusted for inflation in 2015, down from 2.3 percent in 2007.

The neutral setting is expected to rise over time as the economy returns to its full potential, but expectations for that longer-run rate have also dipped. Fed officials’ median projection stood at 3 percent in June before counting for inflation, down from 3.75 percent a year earlier.

Various forces could be driving the drop, but much of it boils down to a lack of demand — and that’s where inequality comes in.

According to secular stagnation, a theory developed by economist Alvin Hansen in the late 1930s, lower population growth rates cause an oversupply of savings, suppress aggregate demand and drive down growth. Harvard economist Lawrence Summers has suggested the 2008 crisis may have ushered in a new era of such mediocrity. As a result, the short-term neutral rate of interest may be lastingly lower.

Inequality effect

Higher inequality has caused a shift toward saving, Summers said in a 2014 speech. “Reduced investment demand and increased propensity to save operate in the direction of a lower equilibrium real interest rate,” he said.

Last year, the top one percent of American households took home $1 million in income on average, not including capital gains, and held 18 percent of the total income share in the country, based on data from the World Wealth and Income Database. That’s up from 13.5 percent two decades earlier and 8 percent in 1960.

Levine, who is a member of the inequality-focused network Responsible Wealth, retired in 1999 at age 52 after a career on Wall Street. Even though he lives off a small part of his investment income, that’s still sufficient to maintain a home on Central Park West and a house in the country, while indulging a love of fine dining — he recently took a party of nine or 10 guests to Del Posto in New York, where a five-course dinner starts at $149 a head before wine.

Rich problem

Levine said that today’s CEOs and top earners also live on a fraction of their income. “Even those with the very highest incomes probably don’t have consumption expenditures for the most part that are bigger than $5 million, $10 million — it’s hard to spend more than that.”

While saved money finds its way back into the economy in other ways — money parked at banks can be lent, for instance — at the end of the day, money may stimulate less demand in the hands of the rich because the overall demand in the economy for discretionary products and services is reduced.

“It’s a kind of chicken and egg thing — just having money in the bank doesn’t mean that there are profitable lending opportunities,” said John Schmitt, research director at the Washington Center for Equitable Growth. “If they’re sitting on all this money, they have a sense that there’s not enough demand out there.”

What’s up for debate is how significant of a factor inequality is in actually lowering rates. Eggertsson said that his preliminary works suggests it has played some role, and he suspects that it’s “non-trivial” — though the research will need to bear that out.

Not everyone agrees. Former Minneapolis Fed President Narayana Kocherlakota said that while the prospect that inequality is lowering the neutral rate is “very interesting argument and it’s one that’s worth pursuing — it’s not one that immediately strikes me as being compelling.”

Kocherlakota, who is a Bloomberg View columnist, reasons that inequality has been climbing for a long time, yet the neutral rate’s major moves, based on most models, have come since the financial crisis. Others, including Schmitt, argue that inequality’s full effects didn’t manifest themselves in the run-up to the housing crash because middle-class households boosted borrowing and spent out of their home wealth to mask their falling share of overall national income.

Silver lining

It could create room for action if inequality is part of the reason interest rates are lower. Fiscal policies can be designed to lessen inequality. There’s no real solution to structural forces that have pushed down neutral rates, like the aging of the population.

“Some of these forces are unlikely to revert back,” Eggertsson said. And society may find that it wants natural rates higher, because the lower they are, the less ammunition monetary policy can provide in a crisis. “We’re one shock away from hitting the zero bound again — that can create difficulties.”