A Compassionate Monetary Policy Requires Targeting Low Inflation

The elections of 2024 provide an opportunity to assess recent policy decisions and begin 2025 with a fresh start in federal policy. With this in mind, we present the following monetary policy assessment and recommendations for the next president and 119th Congress: 

• Pandemic-era inflation damaged the finances of all Americans, but losses seem concentrated in the middle class. Although there were small differences in inflation rates between income groups, large differences in nominal wage gains resulted in the smallest real wage decline for low-income households. 
• Historically, inflation has been most detrimental to low-income households. Precisely because they consume the most relative to their wealth, they are most exposed to price increases, whereas higher-income households may protect themselves to some extent with inflation-adjusted assets.
• Low-income households are often borrowers, which—to some extent—shields them from inflation because their real interest payments decline.
• Despite the allure of stimulating the economy with the goal of helping the poor, it remains true that inflation hurts all Americans. Consequently, it is critical for the Federal Reserve to commit to a low-inflation policy, for Congress and the White House to commit to fiscal sustainability, and for policymakers to commit to gathering and releasing timely data on the detailed effects of inflation both geographically and across the income distribution.

Background

There is little debate that the early 2020s inflation caused tremendous pain for American households. Economists debate the sources of this inflation; supply-siders point to pandemic-induced bottlenecks that crippled global supply chains while critics of the trillions in COVID stimulus spending point fingers at Congress and its penchant for throwing taxpayer dollars at every crisis. And, of course, others single out the Federal Reserve for being too slow to raise interest rates.

Debates about inflation and its impact on American households typically overlook the redistributive impact on those households and on other parts of the economy. The characteristics of households can tell us quite a bit about who the winners and losers will be. Geography and class, for example, are important determinants of exposure to inflation risk. There is significant regional variation in energy use and which fuels consumers rely on. When oil prices spike, some households are hurt more than others.

Within regions, class plays an important role in the effects of inflation. Households that borrow at fixed interest rates tend to gain substantially from inflation because the real value of their debt payments declines. Rich, older households and bondholders tend to be inflation’s losers while young, middle‐class households with fixed‐rate mortgage debt benefit more from inflation. Business owners feel inflation’s wrath because the tax code offers only nominal benefits to depreciating assets which depresses their real value over time. When inflation rises, they incur substantial losses. 

Nevertheless, low-income households in coastal areas typically suffer the most from bouts of inflation. More important than debt or tax benefits, class and geography predict the extent of a household’s inflation rate quite well. Research from FREOPP finds that low-income households historically face significantly higher rates of inflation, and that is especially true when comparing the coasts (higher inflation) to the middle of the country (lower). The easy explanation for this is mechanical: a larger share of a low-income household’s consumption basket is devoted to precisely those goods that are most prone to inflation such as gasoline, food, and rent. Higher-income households, in contrast, spend quite a bit on services and luxury goods, which typically are not as volatile. Moreover, high-income households are more likely to purchase goods which have experienced significant innovation in the last few decades like computers, televisions, and other electronics, all of which have seen significant price declines. The coastal explanation is likewise simple: it is largely driven by differences in housing costs and a complex infrastructure and regulatory system that exposes coastal areas to greater inflation pressure than the middle of the country.

Figure 1 demonstrates both the predictive power and the vital necessity of considering geography and class for analyzing inflation. We plot cumulative inequality between the bottom and top income deciles, between the Pacific Coast and the Upper Midwest, and, in blue, between the bottom income decile in the Pacific Coast and top income decile in the Upper Midwest. Cumulatively, prices are only 10 percent higher for the bottom income decile than the top decile since 1979, 20 percent higher in the Pacific Coast than the Upper Midwest, but nearly 40 percent higher when considering both geography and class. 

Figure 1. Cumulative inflation inequality is defined as the ratio of price levels normalized to be the same starting in 1979. We define geographic inflation inequality between the Pacific Region and the Upper Midwest. Income inflation inequality is between the top and bottom deciles of income.

However, in a historical aberration, both higher-income households and households in the Midwest initially fared much worse at the start of the recent inflationary surge. Initially, the Midwest experienced much higher price inflation than the Pacific, but that quickly reversed when energy and housing prices picked up in 2022. The same is true, but to a lesser extent, for the differences between the bottom and top income decile.

Figure 2. We define geographic inflation inequality between the Pacific Region and the Upper Midwest as the difference in inflation rates. Income inflation inequality is between the top and bottom deciles of income. Data are smoothed with a three-month rolling average. 

At the same time, the relevant factor for households is not just the prices they pay, but the wages they receive. Economists have documented a significant amount of wage compression during the recent inflationary surge. With FREOPP’s geography-by-income inflation indices, we can paint a clearer picture of wage gains by region. 

Figure 3. Real wages relative to February 2021 by income quartile and region.

The bottom half of the income distribution saw real wages rise considerably in some parts of the country and steep drops in others, complicating the story about wage compression. In some parts of the country, the experience for the bottom half is similar to the top’s: real wages remain below where they were more than three years ago. Depending on how quickly firms raise wages in response to an inflationary shock, inflation can cause real wage losses if those nominal wages do not increase in line with inflation. That discrepancy between wages and prices has been very apparent during the most recent inflation shock in the United States. Because low-income jobs have more flexible wages with shorter-term contracts, nominal wages were slightly more likely to keep up with inflation for lower-income households, which meant that wage drops were smaller.

These observations on inflation and real wage growth may present policymakers with a tantalizing opportunity to deploy inflation as a quick fix for inequality. The ability to use inflation to redistribute income, however, is nothing more than a phantasm.

Although inflation and wage growth appear to have been worse for the high-income households, there are three reasons why that may not be so. First, poor households typically consume a substantially larger portion of their income than high-income households. Indeed, for the poorest fifth, the consumption rate is close to one—or total. In the end, policymakers evaluate well-being through consumption and by this standard, poor households have suffered the most because so much more of their consumption is inflated away. Second, for a similar reason, real wage declines may be worse for low-income households even if higher income households must endure higher negative returns.  Higher income households typically have other sources of income which are unaffected by inflation or possibly even aided by it, like capital gains. Finally, being poor by itself exposes a household to more negative shocks. A rich household can often access a large safety net of assets and networks to cushion a few percentage point increase in inflation. A low-income household, on the other hand, may face a choice between driving to work and feeding a family. Low-income households face tight budgets and have little margin for error; every cent may matter. Any level of unexpected inflation often proves enough to overcome that little margin of error and overwhelm the household’s budget. In that sense, it does not matter that real wages may have declined slightly less for low-income households or that inflation was slightly higher for high-income households in the pandemic-era inflation anomaly. For these households—and for evaluation of policy generally—all that matters is that their budgets were overwhelmed by unaffordably rising prices.

Figure 4. Cumulative purchasing power-adjusted inflation by income quartile is defined as the product of inflation for each income quartile multiplied by the consumption share of income.

Federal policy recommendations 

While academic economists debate whether or not the recent inflation was caused by monetary policy or pandemic-related disruptions, there is nothing precluding policymakers from tackling both sources of inflation. We have one recommendation for each of fiscal and monetary policy together with a technical recommendation for policymakers more generally.

Appointees to the Federal Reserve should commit to a low inflation policy

First, it is inappropriate for the Federal Reserve to abandon its implicit target of two percent inflation. The two percent target is well-grounded in established theoretical models—which emphasize anchoring long-term inflation expectations to promote price stability—and has become a cornerstone of monetary policy. A target of three percent or more would deliberately move away from that and bake-in disproportionately high losses for low-income households. But, more importantly, we worry that any indication that the Federal Reserve will tolerate a measurably higher level of inflation would send a dangerous signal to policymakers that they need not worry about the precursors to inflation, such as endless rounds of stimulus spending and unchecked growth in entitlement programs. And, of course, such a lackadaisical attitude brings severe consequences for the poor. Indeed, given recent evidence, we think that monetary policy should have asymmetric concerns about inflationary risk: high inflation is potentially much worse than low inflation, particularly for low-income households. With that in mind, we think that the Federal Reserve should have raised nominal interest rates in late 2021, when it became apparent that the inflationary uptick was not due to a “transitory” micro-story, such as the surge in used car prices.

The White House and Congress should resist the allure of overstimulating the economy

Fiscal policy works in tandem with monetary policy to address inflation. A prudential fiscal policy should be less stimulative in times of growth and should avoid large deficits when it is far from clear that they are necessary. While we appreciate the variety of fiscal experiments in states from California to Florida, the federal government must be careful to balance its own desires for spending against the stimulative efforts of state governments it cannot control. As a potent example: many state governments distributed inflation relief checks in 2022, thereby generating additional inflationary pressure while the federal government continued to run large deficits. With inflation’s distributional effects in mind, that is an unacceptable oversight, particularly when the monetary authority is struggling to rein in inflation. 

Policymakers should be more transparent with data

We urge policymakers to be careful when discussing different inflation indices. While it is true that the monetary authority may have little power to affect components of inflation like energy, housing, and food, these are universal essentials and matter particularly to low- and middle-income households. Discussions of “core” inflation that strip-out essential aspects of life may be appropriate for some aspects of policy, but it is entirely inappropriate to consider only core inflation when analyzing inflation’s distributional impact. To that end, it is as important for policymakers to emphasize price indices important to the welfare of all Americans as those that are relevant for understanding the effects of policy. Beyond our estimates of inflation by income, it is critical for the Federal Reserve and the Bureau of Labor Statistics to regularly publish more granular data on the effects of inflation on all Americans. We recommend that Congress appropriate funding for statistical agencies to investigate and regularly publish data on inflation by Congressional district, county, income quartile, and other relevant metrics.

Conclusion

Inflation remains poorly understood by both policymakers and economists. It is difficult to discern its causes decades after the fact, let alone in real time. However, a basic grasp of the relevant data indicates that, regardless of cause, the effects of inflation weigh most heavily on the poor. Rather than think of inflation as a necessary evil or even a mildly effective tool in the fight against inequality, policymakers should instead see inflation as an unnecessary evil that hurts everyone along the income distribution. Many well-designed policies—including some from FREOPP—can effectively fight inequality; inflation is not one of them. The time has come for us to instead think of inflation as an anti-growth burden and an unnecessary evil on everyone.