The Federal Reserve has a well-defined dual-mandate: stabilize prices and maximize employment. However, in trying to achieve these objectives, the Fed can inadvertently favor some segments of the population more than others. This was indeed the case from the perspective of households’ net worth position during the Great Recession.
We have already highlighted the highly unequal distribution of financial wealth in the United States in a previous post. One way to think about wealth inequality is that there are two kinds of homeowners. Those at the very top end of the wealth distribution who own most of the stocks and bonds in the economy – let’s call them creditors. And for the rest the single biggest asset is their home – let’s call them debtors. The debtors do not own much wealth outside of their homes, and in fact need to take out a mortgage from the creditors to purchase the house. Of course, the financial system intermediates this process, but ultimately creditors are lending to debtors.
When the economy slows down and there is a sharp decline in house prices, it is debtors who initially suffer. It is the debtors’ net worth that is most heavily impacted, and from a recovery standpoint it is the debtors’ net worth that is in most need of repair (you will have to read our forthcoming book for the full argument).
The Federal Reserve may help in boosting the net worth position of households. But does it boost household net worth where it is needed the most? Unfortunately, quite the opposite is true. The Fed directly controls short term interest rates, and hence has the strongest and quickest influence on bond prices. Bond prices are inversely related to interest rates because lower future interest rates make the future coupon payments paid by existing bonds worth more today. The value of long-term bonds can increase substantially if the Fed can lower expectations of future interest rates.
The chart below shows that at the outset of the Great Recession, both house prices and stock prices tanked. As we have done in the past, we index the values to be equal to 100 in 2006, and so the percentage change from 2006 to any year is just the point for that year minus 100.
While stock prices later recovered, house prices remained depressed for an extended period. However, the one asset that did remarkably well was long term bonds. Those holding long term bonds profited handsomely from the decline in interest rates.
Unfortunately for the macro-economy, the gains in long-term bonds were a unique benefit to creditors. Debtors with a levered claim on house prices remained stuck. This was one of the great limitations of how effective the Federal Reserve could be in the midst of the Great Recession.
Many have placed much blame on the Federal Reserve for increasing wealth inequality. That is unfair — it is not the Fed’s fault that only the very rich hold bonds and other financial assets. But it is true that a by-product of looser monetary policy is a rise in wealth inequality–the Fed was unable during the Great Recession to boost the net worth of debtors.