In all of the recent discussions of income inequality, one major causative factor has been overlooked: Federal Reserve policy. Yet, our experience over the past 12 years, during which the Fed has actively engaged in inflation targeting, is that this policy has been an unmitigated disaster and has dramatically increased income inequality by creating a massive wealth transfer from wage earners to bond holders and lenders, many of which are foreign institutions.
Depressing Nominal Wages
The impact of inflation targeting is pernicious, as it restrains growth in nominal wages (that is, the wage level regardless of any change in the price of goods and services). Since middle-class wage earners are significant net debtors, they benefit more from increases in nominal wages than real wages, as fixed debt service becomes more affordable. In addition, wage earners who are experiencing nominal wage increases have the flexibility to change their consumption patterns to avoid inflationary erosion of their increased wages. Finally, inflation targeting produces severe recessions, which disproportionately impact wage earners that become unemployed. If you asked the average American whether they were more concerned about 3 percent inflation versus a recession, what do you think they would say?
The Fed effectively adopted inflation targeting when Ben Bernanke became chairman in 2006 and formally adopted a 2 percent target in 2012. The inflation targeting policy was unproven with no empirical analysis supporting its adoption, and the 2 percent target was completely arbitrary. It is also logically inconsistent for the Fed to have a dual mandate and a single target.
Bernanke used the inflation targeting policy to justify the continued implementation of one of the most aggressive monetary tightening actions since the Great Depression. The Fed raised rates 17 meetings in a row (14 of those occurred when Alan Greenspan was Fed chair), resulting in a financial crisis that ultimately led to the Great Recession. The financial crisis was a disaster for all income classes—except foreign and domestic holders of government debt who benefited from the dramatic fall in long-term treasury yields.
The data shows the failure of the Fed’s inflation targeting policy and its negative impact on middle-class wage earners. Since 2006, nominal wages grew at approximately 3 percent versus 4.5 percent growth over the prior 12 years. We have completed the economic experiment and the results demonstrate how Federal Reserve inflation targeting has reduced nominal wage growth by almost 33 percent and increased income inequality by favoring bondholders over wage earners.
A Better Idea: Flexible Policies
In an ideal world, we would have a flexible Fed as implemented by Greenspan, where we often had intra-meeting cuts in response to events such as 9/11. And markets were never unsettled by forward guidance as Greenspan speak was famous for its lack of content on future intentions. But if the Fed insists on having a rules-based policy, there are some simple alternatives to the disastrous 2 percent rule. The simplest would be to implement a flexible range of 2 percent to 3 percent which would recognize the notion that very low or negative inflation is equally (or more) dangerous than high inflation.
A more complex approach proposed by academics could target an average rate of 2 percent, which would allow undershoots on inflation to be “banked” to then allow overshoots on the 2 percent rate for appropriate periods. Thus, the average inflation rate over the cycle would still be 2 percent. In addition, since the Fed has a dual mandate it should adopt a minimum nominal wage or nominal GDP target to ensure there is adequate growth in the economy and prosperity for middle-class wage earners.
The Fed has backed off of its hawkish policy that caused the market to pull back sharply during the fourth quarter of 2018. If the Fed sticks to its strict 2 percent target without modification, it is likely to resume its hawkish stance if the economy stabilizes later in 2019. This hawkish monetary policy stance threatens to interrupt the recent trend of rising nominal wages and middle-class prosperity. We must reevaluate the current mechanical inflation target policy before the Fed does serious damage again, as it did in 2008.
Jay Hatfield is founder, CEO and portfolio manager at Infrastructure Capital Advisors, a New York City-based RIA that manages exchange-traded funds and a series of hedge funds.