How inequality is weakening central banks’ ability to fight crises
Inequality isn’t just a social challenge; it also undermines a key economic safety net. New research shows that when interest rates are low and wealth is concentrated, central banks' main tool for monetary policy becomes far less effective.
Central banks often rely on cutting interest rates when the economy slows. It’s a fundamental lever to stimulate borrowing and spending. But what happens in an unequal economy if interest rates are already at rock bottom and can’t be cut any further?
New research by Jesús Fernández-Villaverde (University of Pennsylvania), Joël Märbet and Galo Nuño (Bank of Spain), and Esade professor Omar Rachedi suggests the consequences go far beyond what most economists have considered and could weaken the economy’s ability to recover from crises altogether. “We know the costs of inequality—what if there’s one more, one that limits the power of monetary policy, our main stabilizer?” says Rachedi. Their work appears in the Journal of Econometrics.
What is the ZLB and why it matters
The main stabilizer Rachedi refers to is a central bank’s ability to cut interest rates when the economy slows down. Lowering rates makes borrowing more affordable, which encourages businesses to invest and consumers to spend. When inflation runs too hot, rates are raised to cool things down by making borrowing more expensive and saving more attractive.
However, there’s a limit to how low interest rates can go. When rates approach zero, it’s known as the Zero Lower Bound (ZLB), and policy rates can’t be pushed much further down. The ZLB exists for concrete reasons. First, cash sets a floor: if deposit rates become deeply negative, households and firms can hold paper currency that earns a zero nominal return instead of paying to keep money in the bank. Second, financial plumbing and bank profitability struggle with persistent negative rates, which can impair credit creation. Third, the ZLB warps expectations: if people believe rates can’t fall further, future spending and investment plans adjust, making stimulus less effective. This is why the ZLB is a problem—just when the economy needs support most, the main instrument loses power, raising the risk of deeper recessions, disinflation or deflation, and slower recoveries.
Inequality affects the whole economy
The connection between inequality and macroeconomic stability is straightforward. In unequal economies, wealth is concentrated among households that tend to save more, especially when uncertainty arises. That wall of precautionary saving pushes down the natural real interest rate even in normal times, dragging nominal rates lower and leaving central banks closer to zero as a starting point. When recessions arrive, policy hits the ZLB more often and for longer. The cycle becomes harsher and more uneven: credit standards tighten for cash-constrained families just as working hours become uncertain and wages stagnate, while essential costs don’t wait.
A real-life illustration helps. A single mother with two children works part-time, pays rent, and has little or no savings. It might seem that low rates would help by reducing interest on any borrowing. But in practice, near the ZLB lenders often restrict credit to vulnerable borrowers. With income risk rising and prices for essentials still biting, households like hers are left dangerously exposed when the next downturn hits. “Wealth-poor households suffer more from downturns—and that feeds a vicious cycle,” notes Rachedi.
A new perspective on household decision-making
In the study, to see how inequality changes interest rates and the ZLB, the authors didn’t assume all households behave the same. They built a model with many kinds of families—some rich, some cash-constrained, some able to borrow, others not—and let interest rates sometimes get stuck near zero, as in real life.
To achieve this kind of realism in a study is far from easy: the economy’s fortunes affect each type of household differently, and their choices then feed back into the economy. Tracking all of that quickly becomes overwhelming. Therefore, the authors used a neural network—think of it as a modern AI tool—to “learn” how different households typically save, borrow, and spend when conditions change. The result is a model that keeps people’s diversity front and center while staying manageable to compute. In short, it captures real behavior without drowning in math.
The reality of inequality
The results are sobering. High-inequality economies hit the ZLB more frequently, leaving less room to fight recessions. Average inflation and consumption run lower, consistent with chronically weak demand. And the burden of downturns falls most heavily on the financially fragile, widening gaps further.
Perhaps most significantly, the study shows that when inequality is high and inflation targets remain low, monetary policy is no longer neutral. Monetary policy neutrality is the idea that purely nominal choices—like whether the target is 2% or 3% inflation—should not affect long-run real outcomes. In economy textbooks, changing the target is like changing the markings on a ruler, not the length of the table: it shouldn’t affect the real economy. But with high inequality and a binding ZLB, a lower target pulls nominal rates closer to zero more of the time, raising the frequency and duration of periods when policy is hamstrung and depressing real activity. In the authors’ simulations, when the inflation target is reduced, real interest rates fall nearly twice as much in high-inequality scenarios as in more equal ones—a clear sign that the target choice can have real consequences when the ZLB looms.
Real-world implications
We have seen elements of this pattern over the last two decades. Advanced economies experienced a steady fall in interest rates alongside rising inequality. Ageing populations reinforced the trend: near-retirees and retirees tend to save more, adding further downward pressure on rates. Combine these forces and economies hover near the ZLB more often, with central banks repeatedly confronting the limits of rate cuts.
Rethinking inflation targets
This research should be a wake-up call. To keep monetary policy effective, inequality has to enter the design of the framework itself. That is especially relevant now, as institutions like the European Central Bank revisit aspects of their monetary policy strategy. We often treat the inflation target as a number that never changes. The evidence here points to a more state-contingent approach: when inequality is elevated and ZLB risk is high, aiming for a somewhat higher target—or deploying complementary tools that lift equilibrium interest rates—can restore policy space and strengthen stabilization. When inequality recedes and policy space expands, the optimal target may differ. The point is not to lock in a permanently higher figure; it is to recognize that the effectiveness of monetary policy depends on the distribution of balance sheets it acts upon.
