Ignazio Visco: Inflation, monetary policy and inequalities. Some
thoughts
Speech by Mr Ignazio Visco, Governor of the Bank of Italy, at the IARIW-Bank of Italy
Conference on "Central Banks, Financial Markets and Inequality", Naples, 31 March
2023.
* * *
The return of inflation is severely affecting our daily lives as well as our economies,
posing difficult challenges to central banks, and economic policy in general. In fact,
inflation leads to pervasively heterogeneous distributive effects. One hundred years
ago, John Maynard Keynes emphasised this by writing: "Each process, Inflation and
Deflation alike, has inflicted great injuries. Each has an effect in altering the distribution
of wealth between different classes, Inflation in this respect being the worse of the two".
The social influences of inflation also featured prominently in the classical study of
German hyperinflation in the 1920s by Costantino Bresciani Turroni. Milton Friedman
apparently agreed with this, as he is often quoted as having said that "inflation is the
cruelest tax of all".
Clearly, the effects of high and prolonged inflation cannot be compared to the dramatic
consequences of hyperinflation. Nor is analysing the redistributive effects of inflation
simple and straightforward. The impact it has on the distribution of earnings may not be
the same as its impact on the distribution of household incomes which, in turn, may
differ from its effect on the distribution of wealth. The picture is complicated still further if
we take into account factors such as the consequences of long spells of unemployment
on human capital accumulation and future incomes.
That said, the upsurge in inflation recorded since 2021 has undoubtedly hit poorer
households disproportionately, not least because price increases have affected items,
such as energy and food, that weigh heavier on these households' shopping cart, and
that cannot easily be substituted with an alternative. However, we must note that, while
the excess demand created by the very generous budgetary measures introduced to
counter the negative consequences of the pandemics can be considered, given the
ensuing bottlenecks in supply, the root of the rise in inflation in the United States, it has
also gone hand in hand with stronger wage growth for lower incomes and higher
employment. This has, on average, tended to compensate the negative effects of
inflation on households at the bottom of the income distribution. It remains to be seen to
what extent this compensation has been uniform across all poorer households.
In any case, economic policies can be quite an effective tool for reducing the undesired
redistributive effects of inflation. Recent data for Italy suggest that the impact on the
income distribution of the wave of inflation observed since June 2021 was successfully
mitigated by the budgetary measures the Government has implemented. In addition,
the provisions targeting the less well-off have been the most effective. Other studies for
Italy show that, by the end of 2021, the poorest households - those in the first quintile
of the expenditure distribution - were hit by a higher inflation rate (5.3 per cent, almost
two percentage points higher than that of the top quintile). Nevertheless, the rate of
growth of their total labour income far outpaced, in real terms, that of the richest
households (7 per cent, against a mere 0.8).
The distribution of income and wealth across the population is also significant for the
decision making process of central banks. It plays an important role in the transmission
of monetary policy measures. At the same time, we are aware that monetary policy may
contribute to shaping these distributions at business cycle frequencies, with potentially
important feedback loops on its effectiveness.
There is no shortage of review studies on monetary policy and inequality, so let me
focus on only a few points. First, we need a sufficiently good understanding of the
channels through which inequality affects the transmission of shocks across the
economy. One lesson we have certainly learned in the last two decades (or perhaps
something that has been "rediscovered" after the storm that followed the calm of the
Great Moderation) is that the heterogeneity in the effects of economic shocks is of
substantial importance. There is clear evidence that the collapse of real estate prices in
the United States which followed the burst of the Global Financial Crisis, and the
ensuing marked recession affected households very differently, depending on the
composition of their balance sheets and their sources of income. The distribution of
layoffs was also extremely uneven across sectors, occupations and skills. These
heterogeneities, in turn, translated into very different effects on expenditure among
households, depending on their propensity to consume - a point that has always been
a concern of the Bank of Italy.
My second point refers to the development of new models that account for these
differences. The new class of heterogeneous agent new-Keynesian models, developed
in the last few years by Gianluca Violante and other economists, combines
heterogeneous agents with nominal rigidities. This increasingly substitutes the
assumption of a representative agent present in the dynamic stochastic general
equilibrium (DSGE) workhorse models that have been widely used to study the effects
of macroeconomic shocks. The aggregation of heterogeneous households and firms
implicitly matters, together with liquidity constraints and various kinds of buffers and
rigidities, in the "old-style" macro-econometric models that are still, by necessity I would
say, widely used in generating our forecasting scenarios. Allowing more explicitly for
these characteristics, these new models definitely contribute to improving our
understanding of the ways in which monetary policy operates.
In traditional DSGE models, given the assumption of the representative agent,
monetary policy affects the economy mainly through its direct impact on intertemporal
substitution, in other words lowering interest rates increases aggregate demand by
making consumption today more convenient than consumption tomorrow. In models
with heterogeneous agents, however, we find ourselves observing a lesson we learned
a few decades ago, that the indirect effects taking place via changes in demand and
employment outweigh the direct effects of interest rate changes on the propensity to
save. Thus, the shape of income distribution plays a significant role in the impact of
monetary policy on the economy.
In the last few years, research conducted at the Bank of Italy based on this class of
models has shown, for example, that a higher propensity of households to save,
possibly due to perceived greater risks of unemployment, may imply stronger effects of
monetary policy. This would certainly not appear in models built around the
representative agent, because the latter, fully insured over time, would save and
consume regardless of their employment status.
More in general, and this is my third point, models with heterogeneous agents allow for
a deeper understanding of the effects of aggregate uncertainty as well as its
interactions with idiosyncratic uncertainty and non-linearities, such as the presence of
an effective lower bound for interest rates. Another study carried out at the Bank of Italy
in particular shows that the reduction in output that follows a shock to the economy is
much higher in the presence of macroeconomic uncertainty due, in large part, to
heterogeneities between households.
These are not just academic curiosities, even if they require more in-depth study and
testing. They are clearly relevant today, as central banks are in search of the right
balance between two risks. On one hand, easing monetary restrictions too early could
cause inflation to remain persistently elevated and entrenched in price and wage setting
run-ups. On the other hand, ending the restrictive stance too late (or making it far "too
strong") could lead to significant negative repercussions for economic activity and
financial stability, resulting in medium-term excessive disinflation.
As I have mentioned, monetary policy is not only affected by inequality but also affects
it in various ways. For example, lowering interest rates reduces the debt burden and the
returns on savings and may lead to higher asset prices. Over time, it tends to spur
economic activity and push up labour demand, as well as wages and consumer prices.
Depending on expectations and on the shape and position of a complex relation such
as the Phillips curve, it may lead to higher inflation. It is clear that, by taking any one of
these channels in isolation, the effects of monetary policy look very uneven, as they
would, for example, influence debtors in one direction and savers in the opposite one.
Since these mechanisms also work in reverse, this may explain why central banks are
criticised both when they lower and when they raise interest rates.
What is perhaps especially interesting for the discussion generated during this
conference is that, both when monetary policy becomes more restrictive and when it
becomes more expansionary, central banks always continue to claim that they do not
contribute to increasing inequality! However, to a certain degree we may find that this
claim is to some extent supported by literature. Indeed, once all the channels
mentioned above have been aggregated, losses and gains may appear more or less
evenly distributed across households.
At the Bank of Italy, for example, we have extensively analysed the consequences of
the ECB's accommodative monetary policy in 2011-12, following the very dismal
consequences of the euro area sovereign debt crisis. If anything, the expansionary
stance during those years contributed to reducing income inequality in Italy, mainly by
supporting the employment and wages of low-income households. The response of
households' net worth was, however, slightly U-shaped along the wealth distribution:
richer households benefitted more than the average from the expansionary policy,
thanks to their capital gains, but poorer households also enjoyed a larger advantage,
due to their higher leverage. The different response of income and wealth inequality
highlights the fact that we need to be more precise when defining exactly the "inequality
of what" we are analysing.
The recent pandemic emergency has shown the importance of another channel through
which monetary policy may affect inequality, albeit largely indirectly. Focusing on the
first wave of infections, simulation results show that the public policies implemented in
Italy to support workers and households during the first half of 2020 were successful.
The post-transfer Gini index of the labour income distribution remained, in fact, almost
constant compared to pre-crisis levels, instead of rising by several percentage points,
as would have occurred in the absence of any intervention. Actual data on household
incomes have later confirmed these early assessments.
Monetary policy seemingly plays no part in this story. However, we should remember
the severe tensions that arose in financial markets in March 2020. It is therefore
reasonable to argue that introducing those public measures would have been much
more difficult, even impossible, without the extraordinarily expansive monetary policy
that was put in place, including the introduction of the ECB's Pandemic emergency
purchase programme and the strengthening of the Asset purchase programme.
Although the "fiscal dominance" alarm bell may now be ringing for some of you, these
considerations do not suggest that central banks have become dependent on national
governments, but rather highlight the importance of the complementarities between
fiscal and monetary policies. These complementarities not only concern the response to
the deflationary pressures that we observed before and during the pandemic, but also
affect, as we speak, the fight against inflation.
The experience of Italy, in this respect, is particularly insightful. In this country, the
"conquest of inflation" took a long time, as we lived through the two dismal decades of
the 1970s and 1980s. It has to be acknowledged that the economy was then subject to
very severe shocks (and if there is one thing that I have learned during my long
experience in central banking, it is that we may only dream of steady states and the
like!). Following the conflicts of the "hot autumn" of the late 1960s, a weak Italian
economy, and society, had to face the collapse of the Bretton Woods fixed exchange
rates system and the two major oil shocks that followed the Yom Kippur war and the
Iran revolution. Disinflation took place via a long process that only began in the early
1980s, with the strengthening of the central bank's autonomy and the independence of
monetary policymaking.
This in itself, however, was not sufficient. Fiscal policy remained strongly expansionary,
with public debt rising apparently without constraint, and de jure or de facto wage
indexation mechanisms fuelling wage-price spirals (the automatic redistributive
consequences of the scala mobile, the formal indexation scheme, strongly contributing
to the run-ups). Consequently, inflation remained persistently high. Only in the
mid1990s, with a more cautious fiscal policy and the income policy agreements that took
place following the major crisis of the European Monetary System, did the restrictive
stance of monetary policy succeed in bringing inflation down, a necessary condition to
Italy's participation, since 1999, in the Economic and Monetary Union.
Times and conditions are obviously very different now but, based on that experience, I
cannot help observing that, today, swiftly restoring price stability not only depends on
the ECB's action, but also hinges on prudent fiscal policies, on responsible strategies
among businesses and on reasonable agreements regarding labour costs. All of which
is, obviously, easier said than done. But I believe that we must try harder to achieve it.
My final thoughts concern measurement. Measuring the distribution of income or wealth
poses a number of conceptual and practical challenges. Today, we have a multiplicity of
sources, which range from household surveys to various administrative archives. Each
source has its own pros and cons. As far as surveys are concerned, it is well known
that they are affected by selective non-response and underreporting, which clearly
cause problems for the measurement of inequality. The Bank of Italy has a long
tradition in the field, as its Survey on Household Income and Wealth (SHIW) goes back
to the early 1960s. Over time, we have made extensive efforts to correct for these
biases using calibration techniques and satellite data sources. This has enabled us to
address several important issues with greater confidence, as shown in one of the
papers presented at this conference, on the financial fragilities of Italian households
during the last twenty years.
Much effort is currently devoted to developing timely estimates of inequality. Recent
studies by the Eurosystem have made progress in constructing distributional financial
accounts, which allow us to go beyond aggregate statistics. This distributional
information is timely, available at higher frequency, and consistent with the national
accounts. While these results are promising, more must undoubtedly be done, and, as I
understand it, more is indeed in the pipeline. We also need distributional data on
leverage, net savings and investment across non-financial corporations, and it is good
to know that a pioneering production process has been initiated, as has been presented
in another paper during this conference.
The Bank of Italy's membership of the International Association for Research in Income
and Wealth since its creation in 1965 bears witness to the attention we give to the
measurement of income and wealth, covering both the aggregates and their
distribution. Since its first Presidency, under Simon Kuznets, this Association has
played a key role in the conceptual advancement of national accounts and in the
analysis of the distribution of income and wealth. We are pleased to have actively
contributed to both the organisation and the content of this conference, the third ever
held in Italy.
* * *
Let me conclude. Inequalities must be taken into account by central banks, as they are
intrinsically related to inflation and because they affect, and are affected by, monetary
policy. Nevertheless, addressing inequalities remains primarily a responsibility of
governments. Only governments possess, in fact, the democratic legitimacy to assess
how much redistribution is needed. Only governments can apply the most suitable
tools, including taxation, transfers, access to education and the provision of other public
services, not to mention market regulation.
I therefore believe that including inequality in the mandate of monetary policy would be
unwarranted. However, objectives such as improving financial inclusion and financial
literacy are becoming increasingly more important to the realm of central banks'
activities. These are indeed important components of a stable and well-functioning
financial system, and may have the beneficial side effect of reducing the inequalities of
income and wealth.
We must also remember that, when monetary policy decisions are implemented, there
will inevitably be individuals, households or businesses who perceive they are being hit
harder, and some actually will be. Therefore, in pursuing our price stability mandate, we
should not shy away from recognising that our measures also have consequences, at
business cycle frequencies, on the distribution of incomes and wealth. This is so both
when the threats we face are due to an overheated economy as well as when they stem
from unemployment plainly being too high.
Indeed, central banks contribute to the achievement of stable financial conditions and
act in order to maintain price stability, often in the face of shocks that are as hard to
foresee as they are to master. If they succeed, this will result in an economic
environment more conducive to robust, sustainable and inclusive growth. The task is
not an easy one: we need vision and knowledge, courage and solid efforts to better
understand the complexities of the real world. As we proceed in this endeavour, we
certainly need good models and good data, the subject matter of this conference and
more to come.