Is the Federal Reserve to Blame for Income Inequality?

The most intriguing and damning statement about America’s growing income inequality comes from a surprising source: Wellington Denahan, the Chairman and Chief Executive Officer of bottom-feeding mortgage real estate investment trust Annaly Capital (NYSE: NLY).

In a surprising statement in her Fourth Quarter 2014 earnings report, the MREIT boss sounded more like Bernie Sanders or Thomas Piketty than an investor in mortgages. Housing Wire reported that Denahan noted that the extent of the inequality is far worse than we thought, and she laid the blame for the problem on a surprising culprit: the Federal Reserve.

The most disturbing part of Denahan’s assessment of inequality was the numbers she laid out. The numbers, which she apparently got from a recent report from the International Monetary Fund, show the problem is far worse than we thought:

“Since 2009 when the experiment began, global bond markets have increased in value by roughly $17 trillion, or the size of the U.S. economy, while global equity markets have increased in value by a staggering $40 trillion,” Denahan said. “Yet the American wage earners have gained a relatively paltry $722 billion in comparison during the same period. Or to put it more clearly, for every dollar gained by the American worker, the global equity markets have gained $55.”

The experiment Denahan mentioned is the Fed’s policy of quantitative easing (QE), the strategy of keeping interest rates down by buying massive amounts of mortgage securities to keep money cheap. The idea behind QE is that flooding the economy with lots of cheap money will drive economic recovery by encouraging spending.

The numbers Denahan quotes correctly show that the average American is not participating in the “economic recovery” in any significant way. The majority of citizens are unable to capture any meaningful proportion of the new wealth being generated.

The policy has not worked, and it could be setting the stage for more economic upheaval in the near future. The recent increase in foreclosures and the regional real estate bubbles in the United States could be the beginning of this. Denahan also delivered a warning that we should pay attention to.

Is Deflation Coming?

She warned that the United States could soon face deflation. Deflation occurs when assets suddenly lose most of their value. In a period of catastrophic deflation, all assets—stocks, real estates, collectibles, precious metals and commodities—lose most of their value. That drives down prices and wages, causing the economy to grind to a halt, which is what occurred during the Great Depression. We have recently seen deflation in oil and natural gas prices.

“But I fail to see how encouraging greater indebtedness at inflated asset prices will translate into future sustainable growth,” Denahan said. “Unfortunately, if policymakers truly hope to avoid the negative economic menace of asset price deflation, they will need to be in a position to maintain their easy money stance for longer than they currently desire.”

The Annaly CEO also made two other disturbing warnings here. First that quantitative easing and low interest rates will have to be maintained for a long time to prevent inflation. Denahan thinks the Fed will have to keep interest rates low for a long time to prop up the prices of assets like real estate and stocks.

The second warning is that the amount of debt is increasing dramatically because low interest rates encourage people to borrow money. That could be dangerous, particularly in a time when many people are barely making enough money to pay their loans off.

Is Denahan Right?

There is some merit to Denahan’s arguments; quantitative easing does drive income inequality in two ways:

• By keeping interest rates low, it limits the amount of money people can make from interest earning investments like savings accounts, CDs and bonds. Those are the instruments in which working and middle class people are most likely to invest their money.

 

• It increases the value of assets like stocks and real estate because those with cash buy them to get a higher return. That benefits those with money—the wealthy—at the expense of everybody else. One problem is that as the cost of those assets increases, it gives those who own them more money and makes it harder for others to buy such money-making assets.

Another danger is that low interest rates distort the economy by driving money into certain areas, usually the stock and real estate markets. That makes less money available in other sectors of the economy. It also benefits the wealthy, who are most likely to own such assets.

This creates a vicious cycle in which the rich get richer because they use the additional money they make from their investments to buy more stock or real estate. Wealth gets more and more concentrated in a narrower and smaller segment of society.

Denahan is right; quantitative easing has failed, and we need new policies and economic thinking. Unfortunately, we are unlikely to get such policies because our political leaders are afraid to address economic policies, so the job gets dumped on the Fed.

One reason for quantitative easing is that Congress refuses to make large-scale investments in the economy; in other words, increased spending on things like social programs or public works. Such spending might actually stimulate the economy and have widespread benefits by putting more money into people’s pockets without causing inflation. That means it is up to the Federal Reserve to do the job.

Another cause could be the Federal Reserve’s mandate to maintain full employment. The Fed has been trying to do this through mortgage investment, which is supposed to create construction jobs. As we have seen in recent years, that hasn’t worked. Worse, we have a situation with high levels of employment in low-paying jobs.

It would pay for our political leaders to pay attention to somebody like Wellington Denahan as the head of a company that depends on investments based on real estate in Middle America; she has her hand on the economy’s pulse. Unfortunately, our political leaders are not likely to listen to her anytime soon; instead, they will listen to those on Wall Street who are profiting from the status quo. I have a feeling that lack of imagination and failure to see the true picture will have a major effect on next year’s presidential election.