The writer is author of ‘Engine of Inequality: The Fed and the Future of Wealth in America’
Like most central banks, the US Federal Reserve has been forced to ask why more than a decade of ultra-loose monetary policy has had such lacklustre economic results. The answer is that bad data lead to bad policy.
The Fed’s data are misleading because they assume the US is the middle-class nation it has ceased to be. Until it uses data that reflect the nation as it is, the Fed will no more get America back to shared prosperity than someone using a map of New Amsterdam will find the pond in Central Park.
Its inflation measures have three significant shortcomings. First, they omit costs such as food, energy and housing. Doing so is tidier, but fails to capture what households actually need and thus what they are likely to do as monetary policy changes.
The second problem is that Fed data are gross — even if its preferred cost-of-living indices accurately measured the cost of a basic basket of goods and services, they do not tell us whether families have the debt-free purchasing power to afford it. Apparently small inflation in a gross index can easily translate into painful penny-pinching or risky household leverage, each of which has an adverse macroeconomic impact.
Finally, the indices do not measure discretionary spending or financial resilience in ways that forecast how price increases actually affect consumption — for whom and in what way. High-wealth households can trim their sails and stay on financial course; the rest of the nation must dip into scant reserves or go without.
Much in current monetary policy is premised on what economists call the marginal propensity to consume — the engine of want that powers demand that then promotes employment and growth or, if unduly overheated, sparks inflation. The Fed still assumes that interest rates drive decisions about how to use discretionary income. But income and wealth inequality is such that now only upper-income households have this marginal propensity, and most of them have more than enough already, so their propensity is small even if their margin is large.
In sharp contrast, low, moderate and middle-income families do the consuming even though their ability to respond to interest rates is negligible. These households have little capacity to increase or shrink consumption in response to changing rates because most of them live from one pay cheque to the next. By one recent estimate, 64 per cent of American households are either financially vulnerable or just coping.
Year on year, the real cost of living in the US has skyrocketed — homes are up more than 12 per cent, a used car is up 21 per cent, and food costs have risen over 2 per cent. The Fed has recognised a few of these cost increases, but chalks them up to “transitory” factors that do not contribute to the sustained inflation it wants to see before it normalises policy. But it is hard to see which structural factors will reverse far enough and fast enough to erase these cost obstacles to family financial security.
In the absence of another deep recession, even a glut of semiconductors or lumber will not lead to deep discounts on any of these essential goods bringing them back to 2019 levels, let alone to levels a family with below median wealth can afford without continuing debt.
The US central bank has played a direct, if wholly unintended, role in driving income and wealth inequality to astonishing heights. It did so not only by misreading the data, but also by misunderstanding its mandate.
The Fed’s governing law requires it to seek full employment measured by those who want to work, achieve price stability based on purchasing power and set “moderate” interest rates.
This is a triple mandate, not the “dual” one the Fed frequently cites, and demands more of the Fed than its preferred version: “maximum” employment and “price stability” measured by the central bank’s own gauge.
Inflation is already a painful tax on low, moderate and middle-income households. Released at the end of May, the latest official US number showed an annual inflation rate of 3.6 per cent based on April prices.
If the Fed permits this tax to go up, it will let the economy run dangerously hot at a time when ultra-low rates, the Fed’s huge asset portfolio and federal government spending are throwing trillions into the economy without any sign of sustained recovery for those who need it the most.
This will not end well unless the Fed recognises the profound impact inequality has on the US economy and recalibrates policy quickly to address it.