SPONSORED:

Can the Fed reduce racial inequality?

Can the Fed reduce racial inequality?
© Getty Images

Congressional Democrats are proposing new legislation that would add an additional mandate to the Federal Reserve: promoting racial equality. According to the Washington Post, the legislation would seek “to minimize and eliminate racial disparities in employment, wages, wealth, and access to affordable credit.” 

This proposal has attracted some criticism, as it is not clear that the Fed has the tools necessary to achieve these objectives. To take the most obvious example, it seems unlikely that the Fed could eliminate disparities in employment, wages and wealth without first eliminating disparities in education, a field over which it has little or no authority.

The Fed does have some regulatory authority over credit allocation, and this is the area where the proposed legislation is likely to have its greatest impact.

ADVERTISEMENT

A number of studies have examined the issue of racial bias in lending and reached conflicting conclusions. A Federal Reserve Bank of Boston study found evidence that some of the disparity in access to credit reflects the fact that minorities have lower scores on criteria such as income and credit rating. But even controlling for these variables, the study found that minorities are less likely to be approved for loans than white borrowers with similar characteristics. 

There are several possible ways to interpret this data. First, the disparity may reflect racial discrimination. According to this view, while highly qualified minority borrowers may be just as likely to be approved for mortgage loans as highly qualified white borrowers, those with subpar records are less likely to be approved than whites with similarly flawed credit histories. 

If this type of racial bias does exist in bank lending, then you’d expect minorities to default on loans at a lower rate than whites, as fewer minority borrowers would have weak credit ratings. Another study, however, found that this is not the case. Perhaps the racial disparity in lending reflects borrower attributes not accounted for in the Boston Fed study. Unfortunately, these default rate studies are also subject to omitted variable bias — it’s difficult to know whether any two groups of borrowers are entirely comparable.

It’s also unlikely that treating minority borrowers differently would be socially acceptable even if based on some sort of statistical justification. It’s doubtful that the public would accept a situation where bankers were using race itself as a crude proxy for hard-to-observe variables. 

As an analogy, society has often allowed auto insurance companies to price discriminate based on age and gender, if based on statistical differences in accident rates. Price discrimination would not be allowed on the basis of race, however, even if some sort of statistical basis were to exist. Given America’s fraught history of racial injustice, race is not viewed as “just another factor.” Indeed, California recently banned even gender-based auto insurance price discrimination.

ADVERTISEMENT

The most controversial parts of the proposed legislation deal with reducing racial differences in broad economic variables such as employment, wages and wealth. In my view, this mandate reflects widely held misconceptions about what the Fed actually does. 

Monetary policy has important effects on a wide variety of economic variables, including inflation, employment, interest rates, asset prices and output. Thus, it is true that monetary policy has a big impact on the economic well-being of minority groups. In that case, common sense suggests that it might make sense to consider racial inequality when making monetary policy decisions. 

Unfortunately, while monetary policy can influence many economic variables, it’s not clear that Fed policy can address economic disparities, at least in the long run. Most economists assume that monetary policy is roughly “neutral” in the long run, which means that a doubling of the money supply will merely double the cost of living in the long run, leaving price-adjusted “real” wages, interest rates and GDP, along with employment, unaffected. Since inequality is a long-run problem, it’s not clear how monetary policy alone could address these (real) disparities. 

To be sure, improved monetary policy would help minority groups, because it helps most everyone. With better monetary policy, recessions would be less severe and we could avoid the sort of high inflation experienced during the 1970s. But the Fed is already trying to do these things under its current mandate.

As a result, I’d expect the proposed legislation to have little or no impact on the day-to-day conduct of monetary policy. The most likely impact would be to make the Fed scrutinize bank lending more closely, looking for racial disparities. In that case, tighter regulations would probably lead to racial quotas in bank lending that favor minority groups, especially from larger banks that are especially closely scrutinized. 

Scott Sumner is an emeritus professor of economics at Bentley University and director of the Program on Monetary Policy at the Mercatus Center at George Mason University.