Sort by

The Fed’s Interest Rate Deliberations—Much Ado About Nothing

The Federal Reserve just released the minutes of its December meeting at which the Fed Funds rate was increased, for the first time in years, by 0.25 percentage points. The vote was unanimous, but the minutes show a great deal of concern that lower unemployment rates have not moved inflation from near zero levels.

Conventional theory suggests that higher employment rates would push salaries higher because of competition for workers and households would spend more, pushing up inflation. Interest rate increases are used by the Fed to moderate inflation. The theory is that this all happens at the “natural” unemployment rate, and we are thought to be there. Despite theory, salaries remain low and the inflation rate hovers near zero as it has for years. 

The Fed’s move is based on an assumption that theory will prevail even if the facts do not support it. Of course, the decision was driven by conservative Fed Governors, encouraged by a dose of politics in an election year that inclines them toward higher rates that might limit growth. But they are also constitutionally concerned about inflation that might devalue asset values, never a good thing for wealthy investors. Progressive Governors acquiesced since it seemed safe to bump rates a bit to avoid criticism in case some inflation lay ahead. At least employment rates, if not wage incomes, seem to be reasonably strong and the budget deal freed up a bit of spending for some fiscal stimulus to complement monetary policy.

There is another way to think about all of this. Perhaps the theory that underlies interest rate policy is simply out of date, no longer descriptive of the economy. The whole theoretical construct revolves around employment, central to a “virtuous cycle:” corporate profits produce business growth, increasing the number of jobs, thereby driving higher wages and fueling consumption that drives up profits. In a capitalist system, recessions (periods of negative growth) occur periodically, reversing the virtuous cycle as jobs are eliminated leading to lower wages and reduced consumption and lower profits. Injection of cheap capital by the Fed through lower interest rates lowers the bar for businesses to expand, generating jobs, higher wage incomes, increased consumption and profits. That obviously did not happen. High unemployment rates persisted for 96 months after the start of the Great Recession despite low rates, much longer than any post-war downturn. Moreover, wage incomes have still not recovered.

An obvious explanation is that the virtuous cycle, a dynamic that underlies the American capitalist economy has fallen apart.

For example, the business cycle of good times followed by recession and then recovery no longer works as it once did. The business cycle should be a process of creative destruction, in which weak businesses may not survive, but their demise makes way for even better businesses that employ workers more reliably. But to the extent that business does not expand its way out of a recession, the destruction occurs but not the creation. Recent academic studies have shown that this is the case. Schumpeter’s “gale of creative destruction” has become a soft breeze. 

The best explanation of this is that the very nature of employment has changed so that the virtuous cycle has ceased to be relevant. This does not refer to differing types of jobs that require new training for workers. It refers to the fact that employment has less inertia. The new form of employment allows employers to respond to incentives as growth recedes and returns in different ways than they could before. Therefore, employers can now manage employment rolls so that they are more precisely geared to the needs of the moment. 

Prior to the 1980s, the employment relationship was stickier (i.e., had greater inertia). Broad benefits packages were more prevalent and unionization rates were higher. As a consequence, hiring and firing was an involved process. Now, terminations are easier and the decision to reduce staff can be reversed more easily if it turns out that anticipated lower sales that justified the terminations did not play out. Therefore, employers are less likely to keep higher levels of employees in downturns, so fewer are on staff when growth returns. Moreover, employers can be more responsive to smaller increments of increased demand using information technology and web-based businesses to match “just-in-time” employment with demand through part-time and independent contractor arrangements. There is less need to hire ahead of time to make certain that the increasing demand can be met so that there is little risk in keeping employment commitments to a minimum.

At the end of the modern recession, growth may not return to levels as high as before, as employers are not incented to increase employee levels and commitments to employees to pre-recession levels. Employers no longer have to both retain workers and hire up in advance of growth, in large measure because the employment relationship had greater inertia. This margin of employees over precise need was a form of non-governmental demand stimulation, having an effect similar to unemployment insurance. It also incentivized employers to grow their businesses through new investment at the end of a recession to fit the worker rolls that they already maintained. It may have been less efficient in terms of business profits, but it worked well for the workers and greater growth was linked to profits and employment levels.

With a greater ability to fine tune employment levels, employers are better able to maintain, or return to, profitability without investing in their businesses. The safer approach is to do just that, achieving profitability while eschewing long-term investment in real capital or human assets. Investment in human assets is replaced with part-time, freelance and outsourced labor that requires minimal investment. Expanding the “human asset” metaphor, employers are increasingly renting human assets rather than buying them (buying inferring greater inertia).

This is just what the financiers want, of course. Profits without waiting for investments in expansion to pay off yields short-term value, even if it is at the expense of long-term value. The financial sector hangs a big price tag off of companies with such immediate returns and investors respond accordingly. Everybody is happy except for the workers whose salaries stagnate or shrink.  

As a consequence, monetary policy to spur investment expansion is ineffective since businesses prefer to return to profitability without investment in expansion. And wage incomes remain depressed even after growth, albeit modest, returns as the recession ends.

To fix the post-Great Recession economy so that wage incomes recover and businesses return to investment in expansion, the employment relationship needs repair and fine-tuned interest rate policy is largely irrelevant. The medicine to cure our economic ills is old fashioned: stronger unions, higher benefits and reasonable job security.