Monetary policy fails absent the plan’s intervention to solve inequality

“2021 Annual Economic Report,” Bank for International Settlements, June 2021, https://www.bis.org/publ/arpdf/ar2021e.pdf

The impact of inequality on the transmission of monetary policy

Beyond a certain point, inequality across households may weaken the transmission of monetary policy. Households at the bottom and at the very top of the income distribution exhibit low sensitivity of consumption to changes in interest rates: the former may be unable to take advantage of easier credit conditions due to tight borrowing constraints, while the latter have a low propensity to increase their already high consumption.16 By contrast, households at the bottom of the income distribution have higher marginal propensity to consume, and hence are more sensitive to changes in their disposable income.

Empirical evidence suggests that inequality tends to dampen the transmission of monetary policy (Graph II.9). Across countries and time, consumption responds less to an unanticipated monetary policy easing when income inequality is greater – here measured by the share of income accruing to the top 10% of earners. Two years after such an easing, the cumulative difference in consumption growth between a country at the first and the third quartiles of the income inequality measure is estimated to be 0.8 percentage points. This empirical result complements theoretical findings in the recent academic literature, which highlight the importance of household characteristics as a determinant of the transmission of monetary policy to economic activity (Box II.B).

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More broadly, inequality may influence central bank decisions by shaping the political economy environment. Growing inequality can make the public less receptive to central bank actions perceived to increase it. This can constrain the central bank’s choices and eventually hamper its ability to achieve its mandated goals. For example, out of concerns about the impact of higher asset prices on wealth inequality, the central bank could come under criticism for keeping interest rates very low for long periods as it tries to engineer the needed recovery in the wake of a financial recession.