Add or not to add? The Central Bank’s Difficult Choice under a “K-shaped Economy” -- The Federal Reserve’s “Dilemma”

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The U.S. economy is splitting along a "K-shaped trajectory": high-income groups are enjoying asset appreciation and consumption prosperity, while low-income groups are trapped in rising rents, debt pressure, and weak employment. This structural divide is pushing the Federal Reserve into a dilemma that traditional monetary policy tools are unable to resolve.

According to Chase Trader, BofA Securities released its latest research report on June 29, stating that the K-shaped consumption pattern began to appear from the end of 2024 to early 2025, and will intensify further in 2026 due to rising energy prices triggered by the Iran impact—high-income households will receive extra support from tax cuts, while the rise in energy prices acts like a regressive tax, dealing a heavier blow to low-income households. The K-shaped economy makes overall demand appear stronger than it actually is, significantly raising the risk of policy misjudgment.

BofA Securities economists Shruti Mishra and Aditya Bhave clearly state in their report, The Fed’s monetary policy is both a partial cause of the K-shaped divergence and incapable of directly fixing the problem. Faced with the coexistence of "re-inflation" among high-income groups and "mild stagflation" among low-income groups, gradualism is currently the most prudent policy approach, which aligns with the Fed’s recent operational path.

Quantitative portrait of K-shaped divergence: Consumption concentrated at the top

The starting point for understanding the Federal Reserve’s dilemma is recognizing the high concentration in the U.S. consumption structure.

According to the U.S. Bureau of Labor Statistics' Consumer Expenditure Survey, The top 10% of households by income contribute about 23% of total national consumption, while the bottom 10% account for only 4%. This stark contrast means that overall consumption trends are largely determined by the asset-liability condition, wealth effect, and consumption behavior of high-income groups.

Differences in the consumption basket are equally significant. Low-income households (bottom 10%) spend 63% of their expenditure on necessities such as energy, groceries, housing, and healthcare; whereas high-income households (top 10%) spend only 31% on these necessities, with 43.5% going to discretionary service consumption. This structural difference determines that when energy prices or rents rise, the impact falls on the two groups with dramatically different intensity.

Bank card data shows that non-discretionary expenditure (oil & gas, groceries, utilities) for low-income households is squeezed further, compressing their discretionary consumption space and causing K-shaped divergence to expand along this dimension.

How K-shaped economy explains the paradox of "strong consumption, weak employment"

In the past year, the market has been puzzled by a data paradox: the labor market continues to cool while consumer spending remains resilient. The K-shaped consumption structure is key to solving this puzzle.

Because aggregate consumption is dominated by high-income households, who benefit from the stock wealth effect, stable housing costs (many secured pre-pandemic low-rate fixed mortgages), and more favorable financial dynamics, their consumption remains robust even as the job market weakens. Meanwhile, the cooling in employment data is partially due to tightening immigration policy affecting labor supply, but the immigrant group’s share of total consumption is relatively small, further amplifying the divergence between employment and consumption signals.

Since over five-sixths of private sector jobs are concentrated in services, as long as service sector consumption remains solid at the aggregate level, labor demand does not deteriorate sharply. Recent non-farm payroll data comfortably exceeds the break-even level, and employment growth has spread from education and healthcare to broader fields, aligning with BofA’s "optimistic base scenario."

The Fed’s policy dilemma: Both cause and hard to correct

The report points out directly the Fed’s awkward position: monetary tightening has reinforced the K-shaped divergence to some extent, but monetary policy itself cannot directly fix the problem.

Since March 2022, the Federal Reserve has raised rates by a total of 350 basis points; even after rate cuts in 2024 and 2025, current policy rates remain at a high level of 3.50% to 3.75%. Tightening policies exacerbate the divide between income groups through two channels:

First, the credit cost channel. Credit card rates have risen sharply with the federal funds rate. Boston Fed research shows that for every 1 percentage point rise in annual credit card rates, overall card spending drops about 9% the next month, with the impact twice as large for low-income consumers with balances and low credit scores compared to high credit score consumers.

Second, the housing cost channel. Rent inflation has surged during the tightening cycle, while most high-income homeowners remain locked in pre-pandemic low-rate fixed mortgages, keeping housing costs stable. Thus, housing pressure disproportionately falls on the low-income group, who mainly rent.

BofA Securities believes that though Fed Chair Warsh has expressed a wish to reduce divergence through monetary policy, evidence does not support the effectiveness of this approach. The more fundamental problem is that the K-shaped economy creates a policy calibration challenge: high-income groups are experiencing "re-inflation"—robust demand, strong asset prices; low-income groups face "mild stagflation"—weak growth and pressured purchasing power. Two distinct macro environments call for opposite policy prescriptions.

If the Fed focuses too much on aggregate consumption and GDP data driven by high-income groups, it could underestimate the plight of low-income households and maintain overly tight policy. Conversely, if it reacts aggressively to the pressure on low-income households, it could make policy mistakes when demand among high-income groups remains strong and inflation pressures persist.

Therefore, gradualism is the most prudent way to handle this dilemma, which matches the Fed’s cautious actions amid data fog lately. It is worth noting that the Fed’s dual mandate is focused on maximum employment and price stability rather than GDP growth or consumer spending, which objectively helps avoid being misled by aggregate data dominated by high-income groups.

Can fiscal policy fill the gap? Limited space, considerable risks

Since monetary policy can’t directly address K-shaped divergence, can fiscal policy fill the gap? In theory, yes, but practical constraints abound.

Targeted fiscal support—such as direct transfers to low-income households to offset energy price shocks—can act as stabilizers in the short term, as seen with pandemic-era fiscal rescue. However, the fiscal space now is extremely limited. The U.S. fiscal deficit will remain above 6% of GDP, with rising interest expenses, tariff rebates (about $175 billion), supplemental defense spending (potentially about $100 billion), and recent immigration-related appropriations, further straining fiscal capacity.

The deeper risk is that if fiscal expansion pushes up long-term rates and raises term premiums, it could tighten financial conditions via mortgage rates and other channels, causing secondary harm to low-income households—the group policy most wishes to protect. Moreover, further fiscal stimulus might fuel demand-driven inflation, and low-income households are least able to bear inflation, potentially leading them into deeper distress after short-term support.

The effectiveness of fiscal policy in addressing K-shaped divergence is ultimately constrained by fiscal space, inflation risk, and market tolerance for fiscal trajectories—it is not a tool that can be deployed arbitrarily.

Can K-shaped divergence self-correct? Recent signals worth watching

Despite the structural challenges remaining severe, the latest data offers some grounds for cautious optimism.

BofA bank card data for the first half of June show the gap in total consumption (excluding oil & gas) between high-income and low-income households narrowed. Meanwhile, BofA Research Institute reports that after-tax wage growth for middle and low-income households has picked up. If this narrowing trend persists, one possible explanation is that employment growth is spreading into blue-collar sectors such as leisure & hospitality, construction and manufacturing—similar to the pre-K-shaped consumption era, when low-income household spending and wage growth outpaced high-income households.

However, it is too early to declare that K-shaped divergence has permanently turned; recent improvements might partly reflect temporary effects from tax cuts. If the Middle East situation stays calm, oil prices do not surge past $90, and tariff uncertainty keeps easing, the baseline forecast is for a moderate labor market recovery.

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