Tag Archives: Income Inequality

Two Percent for the One Percent

Gradual inflation has a numbing effect. It impoverishes the lower and middle class, but they don’t notice.”—Andrew Bosomworth, PIMCO Germany, as quoted in Der Spiegel

Media reports and political candidates have been stressing the rising wealth and income inequality gaps in the United States. They do so to advance their agendas, but the problem is real and they are justified in raising it. At the same time, both groups are largely overlooking an important piece of the puzzle in the way they talk about it. To properly diagnose this important problem, we need to understand the role the Federal Reserve plays in managing economic growth and how it contributes to these rising imbalances. This article examines the Federal Reserve’s monetary policy objectives and their stated inflation goals to help you better appreciate the role they play in this troubling and growing problem.  

Populism on the Rise

The political success of Donald Trump, Bernie Sanders and more recently Alexandra Ocasio-Cortez leave scant doubt that populism is on the rise. Voters from both parties are demanding change and going to extremes to achieve it. Much of what is taking place is rooted in the emergence of the greatest wealth inequality gap since the roaring ’20s.

Over the last twenty years, the “1%” have been able to accumulate wealth at an ever-increasing rate. According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928. The graph below, while slightly dated, shows the drastic change in income trends that have occurred over the last 35 years.

Graph Courtesy: New York Times – One Broken Economy, in One Simple Chart

This grab for riches by the few is coming at the expense of the many. There are a variety of social, political and economic factors driving the growing discrepancy, but there is one critical factor that is being ignored.

Enter the Federal Reserve

The Federal Reserve Act, as amended in 1977, contains three mandates dictating the management of monetary policy. They are 1) maximize employment, 2) maintain stable prices, and 3) keep long-term interest rates moderate.

These broadly-worded objectives afford the Federal Reserve great latitude in interpreting the Act. Among these, the Fed’s mandate for stable prices is worth a closer look. The Fed interprets “stable prices” as a consistent rate of price increases or inflation. Per the Federal Reserve Bank of Chicago, “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for Personal Consumption Expenditures (PCE), is most consistent over the longer run with the Federal Reserve’s statutory mandate.” 

Understanding why the wealth gap has exploded in recent years requires an appreciation for how this small but consistent rate of inflation harms the poor and middle class while simultaneously enriching the already wealthy.

Wealth is defined as that which is left after consumption and the accumulated results of those savings over time.

With that in mind consider inflation from the standpoint of those living paycheck to paycheck. These citizens are often paid on a bi-weekly basis and spend all of their income throughout the following two weeks. In an inflationary state, one’s purchasing power or the amount of goods and services that can be purchased per dollar declines as time progresses. Said differently, the value of work already completed declines over time.  While the erosion of purchasing power is imperceptible in a low inflation environment, it is real and reduces what little wealth this class of workers earned. Endured over years, it has adverse effects on household wealth.

Now let’s focus on the wealthy. A large portion of their earnings are saved and invested, not predominately used to pay rent or put food on the table. While the value of their wealth is also subject to inflation, they offset the negative effects of inflation and increase real wealth by investing in ways that take advantage of rising inflation. Further, the Fed’s historically low-interest-rate policy, which supports 2% inflation, allows the more efficient use of financial leverage to increase wealth.

Some may counter that daily laborers living week to week get pay raises that offset inflation. That may be true, but it also assumes inflation is measured correctly. The Fed relies upon the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) metrics as gauges of inflation. While widely accepted, we all have firsthand experience of the rapid rise in the cost of health care, higher education, rents, and many other essential goods and services that suggests far greater inflation than the Fed’s 2% objective. The truth is that inflation is not measurable with any real accuracy.

John Williams, of Shadow Stats, calculates inflation based on the methods used by the Bureau of Labor Statistics in 1980. Currently, his calculation has CPI running at 9.9% per year, much higher than the latest 2.2% CPI reported. The difference between Williams’ calculation and the BLS’ reported figure is caused by the numerous adjustments the BLS has made to the CPI calculation over the years which has reduced reported inflation. Economists argue that the BLS adjustments provide better accuracy. Maybe, but the record level of wealth inequality and public dissatisfaction offers hard evidence to the contrary. Disagreements notwithstanding, the loss of wealth due to inflation, whether at 2% or 10%, is punishing for those spending everything as it limits their ability to save and accumulate wealth.

Economic growth as measured by Gross Domestic Production (GDP) is the holy grail of all measures of economic advancement. Rising GDP in a debt-based economy depends on credit growth which explains why inflation is so important to policy-makers. The logical conclusion is that the Fed’s primary purpose for running a consistent rate of inflation is to foster credit growth. The growth of credit benefits those who have collateral to borrow against, employ leverage and invest. Again, it is the wealthy that benefit from this. For everyone else, it is a merciless master that makes it difficult if not impossible to maintain one’s standard of living.

The more of one’s wealth that is used for consumption, the more one is subject to the ills of inflation. Additionally, this circumstance also drives a negative feedback loop in that inflation also quietly incents people to consume since goods and services will be more expensive tomorrow than they are today.

While we illustrate the extremes in this article, one can envision how the middle class, which increasingly spend the majority of their wages on consumption and invest little or nothing, also fall into the inflation trap.

Summary

The central banking scheme of supporting economic growth through increasing levels of debt only makes sense if “growth at all cost” uniformly benefits all citizens, but it does not. There is a big difference between growth and prosperity. Furthermore, an inflationary policy that aims to minimize the burden of debt while at the same time aggravating the growth of those burdens is taking a serious toll on global economic and social stability.

As we are finding, the United States is not immune to these disruptions.  The source of these problems are accumulating and compounding as a result of the public’s failure to understand why it is happening. This will ultimately lead to further policy-making errors. Until the Fed’s policies are publicly discussed, re-examined and ultimately reconsidered, the problems will not resolve themselves.

A Better Way to Gauge Housing Affordability

It’s official — house prices are now as high as they were at the bubble peak in 2006 according to the S&P/Case-Shiller 20-City Composite Home Price Index. Moreover, Americans believe they will continue to soar, according to an article by Quentin Fottrell at MarketWatch.. That makes sense from the perspective of behavioral finance. People often extrapolate recent price movements into the future, which contributes to plenty of misjudgments and sometimes bubbles and crashes.

Does all this mean prices are now in bubble territory again? It’s not so easy to say because a bubble is hard to define. But it sure looks like prices are expensive on some reasonable metrics.

First, it has taken 12 years to regain the 2006 bubble peak. That’s a reasonably long period of time. Also, if prices are indexed to 100 in January 2000 and the index is a 209 now, that means home prices have appreciated around 4.1% annualized. That doesn’t seem like a crazy rate of appreciation,  but the problem is that inflation, measured by the CPI has increased by 2.1% over that time. And median household income has increased by 2.2% from 2000 through 2016.

One problem with this analysis is that the 20-City Index might be weighted more heavily to areas where people’s wages are increasing at higher rates than the median. The U.S. economy is bifurcated now, so that people living in the 20 cities in the index might be doing better than people in the rest of the country. The 20-City index contains New York and San Francisco, after all. Also, at least some of the cities in the 20-City Index suffer from severe supply constraints due to onerous zoning regulations.

New Approach to Measuring Affordability

Not only is measuring median prices to median income across the country inadequate, but so is measuring those things in a particular area. Median income and prices don’t capture the full distribution of incomes, and they don’t focus on renters specifically – those best positioned to become first-time home buyers — according to a recent study by the Urban Institute. Nor do median numbers capture the full distribution of home prices. In some areas, for example, there is a wide variety of homes available, but in other areas there is only a narrow set of home types available. Additionally, focusing on renters is important because renters typically have lower incomes, making them less able to afford a home than the median family.

The Urban Institute’s study creates two new affordability indexes called HARI or Housing Affordability for Renters Index, one for local renters and another for measuring housing affordability for nationwide renters who may move to a region. A local index number means that percentage of local renters can afford to buy a home in that area. Local indexes range from 5% to 37%, while the index covering all renters in the nation ranges from 3% to 42% depending on the region to which a renter might move.

Using Washington, D.C. as an example, the paper shows the steps in the methodology. First, renters’ incomes are broken down into 22 intervals of $10,000, and the percentage of the renter population is indicated for each interval. In DC, more than 40% of renters have incomes in intervals of 1 through 6 or $1 through $60,000. By comparison, 15% of new borrowers have incomes in that range. In interval 7, (incomes from $61,000 to $70,000), the share of renters versus new homeowners with a mortgage is similar. In intervals 8 and above, the percentage of renters is less than the share of new homeowners.

Next, borrower probability for each interval level is aggregated to get cumulative mortgage borrower probability. At each income level, the aggregated number represents the share of houses affordable to renters with that income. So income level 10 ($91,000-$100,000), represents 5.2% of DC renters, and those renters can afford 45% of DC homes that have recently sold. Finally, an aggregate of the share of renters who can afford a house in each income interval is aggregated to arrive at the affordability index. For Washington, D.C in 2016, it was 29.6%, meaning 29.6% of renters in DC could afford a house in DC in 2016.

Nationwide renters have lower incomes than DC renters (70% of nationwide renters have incomes in intervals 1-6, compared to 40% of DC renters). And because of this income difference only 17.1% of nationwide renters can afford a house in DC.

Using St. Louis, Houston, San Francisco and Washington, D.C. (two cities that are intuitively more affordable and two cities that are intuitively less affordable), the new indices show that new borrowers are likely to have significantly higher incomes in the more expensive cities. St. Louis has peak borrower probability of 12% at income interval 4, while San Francisco has peak borrower probability – a little over 5% — at income interval 14.

But the affordability index isn’t determined only by incomes of local new borrowers. That statistic is combined with the full distribution of local renters’ incomes to see if renters earn comparable incomes to borrowers. In St. Louis and Houston, most renters fall in the first 10 income intervals. But in the more expensive cities, there are more renters at higher income intervals.

An interesting result from the study is that “cross-sectional investigation shows that the MSA-level indexes vary less than many might expect.” In other words, the difference between the most unaffordable city – Los Angeles, where 18% of renters can afford to buy – compared to the most affordable – Phoenix, where 31% of renters can afford to buy – isn’t that great. Another surprising result is that Washington, D.C. is more affordable (29.6% affordability) than Houston (22.4% affordability) when considering local renters only. Does this also indicate income and wealth bifurcation? The authors don’t say, but it is a surprising statistic.

There is more to the paper, including a comparison of current affordability to affordability in 2005. That comparison is mostly flattering to the current market, and it may have been better for the authors to consider another point of comparison given the strange market conditions in 2005. Nevertheless, these new affordability indices convey a much deeper and more complex reality compared to, say, the rosier National Association of Realtors’ Affordability Index, which has current affordability at over 100 (meaning median income can afford the median home assuming a 20% down payment) in every region of the country.