The Fed's Twist May Increase Inequality

If it succeeds in pushing down longer-term interest rates, relatively wealthy Americans may benefit more than others

The past recession has been particularly hard on middle- and lower-income Americans. The millions of people who suffered foreclosure were mostly in these groups. Millions more remain unemployed. So as the Federal Reserve steps back in to provide more action meant to fuel the economy, we should ask whether its policies will really benefit those who need assistance the most. Unfortunately, it will instead benefit the relatively affluent.

What We Know About the Fed's Actions

If you aren't familiar with the action announced last week, check out this post. Basically, the Fed will take two separate actions that appear to be primarily aimed at the housing market. One, which commentators refer to as "Operation Twist," intends to push down longer-term interest rates (like those on mortgages). The other more directly hopes to push down mortgage interest rates.

In all likelihood, mortgage interest rates will decline through this action. Unless some unforeseen economic shock hits, mortgage interest rates will hit historically low levels. This could have a few outcomes.

First, we will very likely see a boom in mortgage refinancing: many Americans will want to take advantage of those once-in-a-lifetime mortgage interest rates to cut their monthly payments.

Second, home sales could rise. These extremely low mortgage interest rates could lure more Americans to purchase a house.

Who This Helps Directly

What do we know about those Americans who are able to refinance at this time? They're doing relatively well. Their home isn't underwater, and they have pretty good credit. While this doesn't precisely describe the rich, it does describe the relatively affluent. The group excludes Americans who face foreclosure due to delinquency, underwater borrowers, and renters.

Of course, the Obama administration wants to change this. It is pushing the government-sponsored enterprises to relax its mortgage refinancing guidelines so that more Americans can take advantage of these historically low interest rates. But here's the problem: the GSEs might not go along. At a time when they're struggling to recover providing lower interest rates isn't necessarily in their best interest.

Banks have no obligation to provide refinancing either. As the Washington Post reports, their credit requirements remain very selective. They aren't likely to support a gigantic boom in refinancing by relaxing standards.

Finally, the action will likely have a modest impact on home sales, at best. Mortgage interest rates have already been very low for a very long time, and demand remains dead. Decreasing mortgage interest rates another, say, 0.5% probably won't suddenly entice millions of renters to buy a home.

The Result: The Well-Off Become Better-Off

Since the GSEs and banks won't budge much, struggling homeowners who need mortgage refinancing the most won't be able to take advantage of the low interest rates resulting from Fed's actions. Those who do grab those ultra-low rates will be the relatively affluent. Renters will feel no direct impact.

Because home sales aren't likely to suddenly soar, any additional purchases will mostly soak up some of the huge existing inventory. That means a big jump in construction jobs isn't likely either. At best, we'll see a minor uptick in employment as firms hire to meet additional demand by those relatively affluent who have more money to spend thanks to their lowered mortgage payments.

So in the short-term, the Fed's action will leave those in the worst situations hoping for a mere trickle-down effect. A handful might find jobs a little sooner, but the rest will be left either renting or living in a home with a relatively high mortgage interest rate. And many of those borrowers will remain underwater.

In a sense, this action will widen income inequality. Think about what's happening here. Mortgage interest rates spur refinancing. Those who take advantage will obtain smaller mortgage payments, which will boost their after-housing disposable incomes. Meanwhile, those who are unable to benefit from the low interest rates will have the same after-housing disposable incomes as before.

This will have long-term revivifications, because we're talking about long-term interest rates. Once the Fed's action ends next June, the U.S. may not see mortgage interest rates so low for decades, if ever. Over this period, anyone who refinanced will have relatively cheaper housing than everybody else. Distressed homeowners will be stuck with their higher interest rates. Renters who buy a home in subsequent years will also face higher interest rates.

The Fed's action may still be a good idea, if it does manage to have a significant trickle down benefit on employment. But it will certainly make the relatively affluent better-off, while we can't be sure that struggling Americans will get any relief.

Image Credit: REUTERS/Stelios Varias