Changing monetary policy away drives inflation---that’s worse for inequality in the long run

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

Trade-offs between actions aimed at achieving monetary policy objectives over different horizons have always been present. But changes in the nature of the business cycle since the mid-1980s have complicated the monetary policy task of keeping the economy on an even keel and exacerbated those trade-offs. As a result, the impact on inequality has also become more complex. The root cause has been a shift from recessions mainly induced by a monetary policy tightening to keep inflation under control to recessions in which financial factors play a key role in amplifying business cycle fluctuations, ie the financial recessions noted above.20 The shift is illustrated in Graph II.10, which covers a sample of AEs. Until the mid-1980s, in response to a rise in inflation (left-hand panel), the central bank would tighten policy considerably in the lead-up to the recession (centre panel), while nothing much would happen to credit – here measured by the deviation of the credit-to-GDP ratio (right-hand panel) from its long-term trend. Since the mid1980s, by contrast, with inflation lower and more stable, monetary policy has not tightened much, but a major expansion of credit has given way to a subsequent sharp contraction, inducing a stronger and more prolonged monetary easing. This explains why measures of the financial cycle, or those of “froth” in credit markets, have become more useful for predicting turns in the business cycle. For instance, debt service ratios that are well above historical averages are a drag on GDP growth and signal a likely recession ahead.21

Two factors have contributed to this fundamental change in the nature of business cycle fluctuations. On the one hand, central banks have largely tamed inflation. Delivering low and stable inflation has cemented central banks’ inflation- fighting credentials, helped anchor expectations and, in the process, contributed to making inflation less sensitive to pressures arising from tight economic conditions – the so-called flattening of the Phillips curve.22 Structural factors, notably globalisation and technology, have strengthened these developments. On the other hand, financial liberalisation, both within and across national borders, has increased the scope for financial factors to influence household and business spending.23 The self-reinforcing interaction between funding conditions, risk-taking and asset prices lies at the heart of the corresponding amplification mechanisms.24 As just one example, a significant share of households’ borrowing, particularly in AEs, now takes place using housing as collateral; as a result, house price fluctuations have much larger reverberations in the economy as a whole.25

[[Figure Omitted]]

This has given rise to a more complex intertemporal policy trade-off, reflected also in the relationship between monetary policy and inequality.

On the one hand, low and stable inflation, well anchored expectations and a flatter Phillips curve have provided central banks with greater leeway to be accommodative and let the labour market tighten. A dynamic and inclusive labour market may also limit scarring effects in the short and medium run. By the same token, it reduces income inequality. Such an accommodative policy stance is all the more justified where there are concerns that inflation is persistently below target, as in most AEs over the last decade, where unemployment remains high26 and limited policy space makes the economy more vulnerable to deeper recessions. These conditions help explain why labour markets are playing a prominent role in several recent reviews of monetary policy strategies and frameworks in AEs (Box II.D).

On the other hand, pursuing such a strategy is not without risks. Protracted periods of easy monetary conditions can support the employment and income of the most disadvantaged, but may contribute to the slow build-up of financial imbalances, sowing the seeds of financial recessions further down the road.27 And these are precisely the types of recession that are more costly in terms of income inequality and that require keeping interest rates low for longer, in turn prolonging any possible short-run adverse impact on wealth inequality.