Does monetary policy increase inequality?

Let’s start with a primer on ECB’s interest rate policy. The ECB’s mandate is to ensure that prices remain stable: that they do not rise too much (or too little). By keeping inflation under control, the ECB’s monetary policy helps to mitigate major shocks to the economy. Such shocks can have considerable, and often uneven, consequences for households. At the same time, the ECB’s policies themselves may also affect different households in different ways, giving rise to the question as to whether monetary policy also has an impact on inequality.

Monetary policy does not work the same way for everyone

As every household has different levels of income, assets and debt, each household is also affected differently when the ECB raises or lowers interest rates. This works through three channels.

• The labour market
  Lower interest rates reduce income disparities between households through the labour market channel. Lower interest rates stimulate the economy, resulting in more jobs and higher wages. This is of particular benefit to lower-income households. When interest rates rise, the economy slows down and this channel generates the opposite effect.

• Wealth and asset prices
  At the same time, lower interest rates typically lead to higher prices on the housing and equities markets, an effect that richer households benefit from. Higher interest rates generally result in the opposite effect.

• Interest rates and debt
  Changes in the ECB’s policy rates also affect interest rates on savings and mortgage loans. Lower interest rates reduce monthly loan repayments, while also reducing the return on savings. When interest rates are higher, the opposite is true.

These transmission channels can produce different effects at different times, meaning the effect on inequality may change over time.

What do the latest research findings reveal?

To gain a better understanding of these effects, we combine insights from the economics literature with new model-based evidence in a new analysis.

Building on academic research, we have developed a model that explicitly takes into account differences between households in terms of income and wealth.  This allows us to further improve our understanding of how monetary policy affects different demographic groups across the euro area.

The results (shown in the figure below) indicate that income inequality initially increases in response to an interest rate cut. This is because households with substantial asset holdings benefit directly from rising asset values, such as in equities or real estate. Over time, this picture changes. The economy picks up, leading to an increase in employment and wages. These effects have a comparatively greater impact on lower income households. The earlier effect gradually reverses, leading to a reduction in inequality.

All things considered, the results suggest that the effects of monetary policy on inequality are temporary and relatively modest. This is consistent with existing research, which shows that, in the long term, inequality is primarily determined by broader trends such as an ageing population, digitalisation and globalisation, as well as by fiscal policies. At the same time, we must interpret these findings with some caution, as models such as this cannot fully account for all relevant mechanisms. For example, the housing market, differences in household debt, and unconventional monetary policy also play a role, but are only partially incorporated in the model.

What can we learn from this?

Monetary policy affects different households in different ways but ultimately helps to ensure stable economic conditions. This stability is precisely the most important contribution that the central bank can make to an economy that works for everyone.

The ECB’s focus is on price stability. Understanding how households are affected differently by monetary policy is important, as these differences determine the effect of policy on spending, growth and inflation. At the same time, these effects are usually limited and temporary. Moreover, monetary policy cannot be deployed with surgical precision. Addressing inequality is therefore primarily a matter for governments’ fiscal policies, which comprise a wider range of more targeted instruments.