Our evidence assumes the counterplan’s short term benefits, but finds that inflation-focused monetary policy is best for inequality

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

Changes in the stance of monetary policy inevitably have some short-run distributional effects. Every time the central bank adjusts interest rates, changes its lending terms or purchases assets, distributional consequences follow. For example, any such adjustment redistributes interest income between debtors and creditors and influences asset prices, which reallocate income and wealth in the population depending on holdings (see Box II.C for a detailed analysis of this point). But the more important influence of monetary policy on inequality is through its impact on inflation, employment and economic activity. These are the main macroeconomic factors that shape inequality over the business cycle.

This also means that central bank mandates are fully consistent with tackling the influence of the factors that can raise inequality over that horizon. While mandates have evolved over time, these days they are primarily interpreted as delivering low and stable inflation and limiting business fluctuations – measured in terms of output and employment. And although financial stability need not be mentioned explicitly, it is naturally subsumed under the objective of smoothing fluctuations: just as price stability, financial stability is a necessary condition for output and employment to grow sustainably over time. This is true regardless of whether financial instability is interpreted narrowly – as banking or financial crises – or more broadly – as the amplification of business cycles and recessions induced by financial factors.17

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Once high inflation or recessions materialise, the needed monetary response may have an undesirable short-run impact on inequality, in order to secure the long-term gains. Hence the importance of avoiding inflation and recessions in the first place.

Bringing inflation under control will generally call for a monetary policy tightening, which can induce recessions and hence increase income inequality. In AEs, a clear example is the “Volcker shock” of the early 1980s in the United States, which set the basis for the conquest of inflation. In EMEs, the episodes are more common and severe. For instance, the Central Bank of Brazil had to raise the policy rate by more than 10 percentage points between 2001 and 2003 to rein in a surge in inflation.

Similarly, sustaining a recovery in the aftermath of a severe economic recession requires keeping interest rates low for longer, especially if they are constrained by the effective lower bound.18 For example, had monetary policy refrained from deploying all necessary tools to keep borrowing costs low in the aftermath of the GFC and the Covid-19 pandemic, the recessions would have been deeper and longer. This, in turn, would have exposed the most disadvantaged to longer unemployment spells and worsened income inequality.19 That said, while low interest rates mitigate income inequality substantially, their impact on asset prices, especially equities, may have the side effect of increasing wealth inequality in the near term. This outcome, however, is not a given and may be overturned for certain measures of inequality if home ownership is concentrated in the middle of the wealth distribution (Box II.C).