Why the Fed Raising Interest Rates Matters

The Federal Reserve is the central bank of the United States. There are many valid criticisms of it as an institution, but it can act as a valuable force for the public interest if used properly.

As is the standard of central banks, the Fed has a powerful tool that allows it to have a major impact on short-term interest rates. Interest rates are basically bread and butter to the number of people who have jobs in the economy.

Raising interest rates has the effect of slowing the economy and keeping people — potentially millions of them, as shown in recent years — from finding jobs. Higher interest rates naturally mean less loans to businesses and organizations that could use them to hire more workers. The standard argument for raising interest rates though is to control inflation, as higher interest rates reduce pressure in the labor market, which then leads to workers having less bargaining power for pay increases.

The problem with the argument to control inflation is that inflation has already been quite low in past years, well below the Federal Reserve’s 2.0 percent annual target. The 2.0 percent target is supposed to be an average, and considering recent years, it hasn’t even been near that target. The Federal Reserve was set up with the dual mandate of both adequately controlling prices and maintaining what’s known as full employment. Full employment basically means a strong labor market with low unemployment, where workers can have good access to jobs with fair wages, and it’s quite important as a policy measure. (Due to slow wage growth among most, the U.S. economy clearly isn’t at full employment now, contrary to what you’d likely read in the newspapers.)

If unemployment is low, it means that there will be an increased demand for labor, which should both mean higher wages for workers and that the economy’s resources are being used decently well. The increased demand for labor raising wages is because employers cannot so easily hire other workers if their employees happen to leave the firm. Without enough employees, the firm risks being losing profitability to its competition and going out of business. This situation would allow an existing employee to say something like “Give me a raise or I will find a job elsewhere,” and it would potentially allow a prospective employee to refuse a job unless the wage is adequate enough.

The increase in worker bargaining power leading to higher wages and then higher inflation is due to firms needing deciding to raise prices some after seeing that workers generally can pay more. There is nuance needed in this description, and it should be noted that wages for most workers in the U.S. have been mainly stagnant for decades due to the policy-driven upwards redistribution of income to the wealthy, but it’s a standard point. If the policy is actually directed towards the interest of the general public, the increases in prices will be more than offset by the increases in wages, however. There is evidence of this worker-friendly approach doing well in the U.S. from about 1947 to 1973.

It should also be noted that the only times that many American workers have experienced even minor real wage increases in the last four decades have been when there were tighter labor markets. This occurred in the later 1990s and over the past several years, and it points to the immense importance of the Fed keeping interest rates low.

Alan Greenspan was the economist at the head of the Fed in the 1990s, and for whatever reason, he decided against raising interest rates as the unemployment rate got lower. This was at a time when it was standard in the economics profession to claim that the unemployment rate couldn’t go below about 6 percent without leading to rapid inflation. Inflation never got that high in the 1990s though, and even if Greenspan deserves serious criticism for failing to contain the housing bubble that was the main cause of the devastating economic crash and Great Recession, he does deserve praise for doing this one thing to help low- and middle-income workers.

Janet Yellen’s chair appointment at the Fed also saw the institution keeping interest rates quite low for her tenure, which is clearly one of the main reasons that the U.S. economy is doing decently well now in 2018 relative to the last four decades. Driving around America now would allow someone to see many more help wanted signs than in at almost any other time thus far in the 21st century, and there’s an advantage to this that may not be so obvious: Disadvantaged workers (typically those from minority ethnic groups or with disabilities) will have an easier time finding jobs. The increased demand for labor means that there’s less room for discrimination against them. As proof of this, the disabilities application rate and the unemployment rate for African-Americans have fallen to historically low levels.

The unemployment rate does of course have its flaws. It measures workers looking for jobs, not the amount of people who have dropped out of the labor force and are no longer looking for employment. There is plenty of good work that needs to be done, and there are idle hands that want to do it, but the dysfunctional American economy isn’t putting the two together enough. So while the unemployment rate is an important measure, there are other relevant indicators (such as the labor force participation rate among prime-age workers) that should be considered in assessing the economy.

But if the majority of workers benefit most from lower rather than higher interest rates, why does the Fed continue to raise them then? It’s largely because financial institutions exert significant control over the Fed, and their preference is to keep inflation as low as possible. More worker bargaining power via lower interest rates can mean a shift from net corporate profits to wages for workers, and bank loans also stand to depreciate in value with higher inflation.

The after-tax corporate profit share of national income has almost doubled since 2000, and this to a significant extent is because of wages for workers being diverted into corporate profits that are largely pocketed by executives and major shareholders. According to one reputable estimate, if the after-tax corporate profit share was back at its 2000 level, it would translate to nearly $4000 more per U.S. worker in wages, a fact that is undoubtedly quite disturbing.

The loans of banks and other financial corporations typically are set at a fixed rate, the repayments of those loans will be worth less to them if inflation rises. For one example, if a bank offered a 5 percent home loan while expecting that inflation would be 1 percent, the bank would assume that it would receive a real interest rate of 4 percent. If the inflation rate actually becomes 2 percent, the bank will take a considerable profit loss (receiving a 3 percent real interest rate) compared to what it expected.

In sum though, the issue of the central bank raising interest rates has historically been one that’s favored powerful financial corporations at the expense of the working class, and it’s a very significant issue that should be kept in mind more.

Using Work Sharing to Improve the Economy and Worker Happiness

An important policy idea of reducing average necessary work hours (with at least similar wage levels ideally due to increased value via more productivity growth) that will keep becoming more important as technology continues to advance.

The United States is very much an outlier among wealthy countries in the relatively weak rights that are guaranteed to workers on the job. This is true in a variety of areas. For example, the United States is the only wealthy country in which private sector workers can be dismissed at will, but it shows up most clearly in hours of work.

In other wealthy countries, there has been a consistent downward trend in average annual hours of work over the last four decades. By contrast, in the United States, there has been relatively little change. While people on other wealthy countries can count on paid sick days, paid family leave, and four to six weeks of paid vacation every year, these benefits are only available to better-paid workers in the United States. Even for these workers, the benefits are often less than the average in Western European countries.

[…]

Part of the benefit of work sharing is that it can allow workers and employers to gain experience with a more flexible work week or work year. It is possible that this experience can lead workers to place a higher value on leisure or non-work activities and therefore increase their support for policies that allow for reduced work hours.

Work Hours in 1970: The United States Was Not Always an Outlier

When the experience of European countries is raised in the context of proposals for expanding paid time off in the United States, it is common for opponents to dismiss this evidence by pointing to differences in national character. Europeans may value time off with their families or taking vacations, but we are told that Americans place a higher value on work and income.

While debates on national character probably do not provide a useful basis for policy, it is worth noting that the United States was not always an outlier in annual hours worked. If we go back to the 1970s, the United States was near the OECD average in annual hours worked. By contrast, it ranks near the top in 2016.

In 1970, workers in the United States had put in on average 3 to 5 percent more hours than workers in Denmark and Finland, according to the OECD data, by 2016, this difference had grown to more than 25 percent. Workers in France and the Netherlands now have considerably shorter average work years than workers in the United States. Even workers in Japan now work about 5 percent less on average than workers in the United States.

baker-worksharing-2018-06-fig-1

[…]

It is also important to consider efforts to reduce hours as being a necessary aspect of making the workplace friendlier to women. It continues to be the case that women have a grossly disproportionate share of the responsibility for caring for children and other family members.

[…]

In this respect, it is worth noting that the United States went from ranking near the top in women’s labor force participation in 1980 to being below the OECD average in 2018. While other countries have made workplaces more family friendly, this has been much less true of the United States.

Shortening Work Hours and Full Employment

There has been a largely otherworldly public debate in recent years on the prospects that robots and artificial intelligence would lead to mass unemployment. This debate is otherworldly since it describes a world of rapidly rising productivity growth. In fact, productivity growth has been quite slow ever since 2005. The average annual rate of productivity growth over the last twelve years has been just over 1.0 percent. This compares to a rate of growth of close to 3.0 percent in the long Golden Age from 1947 to 1973 and again from 1995 to 2005.

So this means that we are having this major national debate about the mass displacement of workers due to technology at a time when the data clearly tell us that displacement is moving along very slowly.[2] It is also worth noting that all the official projections from agencies like the Congressional Budget Office and the Office of Management and Budget show the slowdown in productivity growth persisting for the indefinite future. This projection of continued slow productivity growth provides the basis for debates on issues like budget deficits and the finances of Social Security.

However, if we did actually begin to see an uptick in the rate of productivity growth, and robots did begin to displace large numbers of workers, then an obvious solution would be to adopt policies aimed at shortening the average duration of the work year. The basic arithmetic is straightforward: if we reduce average work hours by 20 percent, then we will need 25 percent more workers to get the same amount of labor. While in practice the relationship will never be as simple as the straight arithmetic, if we do get a reduction in average work time, then we will need more workers.

As noted above, reductions in work hours was an important way in which workers in Western Europe have taken the gains from productivity growth over the last four decades. This had also been true in previous decades in the United States, as the standard workweek was shortened to forty hours with the Fair Labor Standards Act in 1937. In many industries, it had been over sixty hours at the turn of the twentieth century.

If the United States can resume a path of shortening work hours and get its standard work year back in line with other wealthy countries, it should be able to absorb even very rapid gains in productivity growth without any concerns about mass unemployment. While job-killing robots may exist primarily in the heads of the people who write about the economy, if they do show up in the world, a policy of aggressive reductions in work hours should ensure they don’t lead to widespread unemployment.

The Sham of “Fiscal Responsibility” in Public Policy

The budgets of a government are different in nature than the budgets of a family, yet it seems that few media and political elites seem to understand this. A sovereign government can for example create more currency (which doesn’t necessarily lead to more inflation, per the quantity theory of money) for various initiatives, an option legally unavailable for personal families.

It’s official: New York Times columnist David Leonhardt pronounced the Democrats as the party of fiscal responsibility. In contrast to three of the last four Republican presidents who raised deficits with big tax cuts for the rich and increases in military spending, the last Democratic presidents sharply reduced the budget deficit during their term in office.

Leonhardt obviously intends the designation to be praise for the party, but it really shows his confusion about budget deficits and their impact on the economy. Unfortunately, this confusion is widely shared.

Contrary to what Leonhardt seems to think, the economy doesn’t get a gold star for a balanced budget or lower deficit. In fact, lower deficits can inflict devastating damage on the economy by reducing demand, leading to millions of workers needlessly unemployed.

This has a permanent cost as many of the long-term unemployed may lose their attachment to the labor market and never work again. Their children will also pay a big price as children of unemployed parent(s) tend to fare worse in life by a wide variety of measures, especially when unemployment is associated with family breakup, frequent moves and possible evictions. Also, lower levels of output will mean less investment, making the economy less productive in the future.

We actually have some basis for estimating the cost of long periods where the economy suffers from insufficient demand. If we compare the Congressional Budget Office’s (CBO) projections for potential GDP in 2018 made before the Great Recession, with their current projections, the gap is more than $2 trillion, or 10 percent of GDP.

That loss comes to more than $15,000 a year for every household in the country. In other words, the CBO’s projections imply that if we had managed to sustain high levels of demand in 2008 and subsequent years, rather than falling into a severe recession with a weak recovery, the annual income of the average household would be $15,000 a year higher.

Racial Unemployment Gap Being Reduced by a Tightened Labor Market

There are numerous benefits to full employment policies. Of course, while there is a relatively tight U.S. labor market, some part of the low unemployment story is due to the significant number of workers who have dropped out of the labor force. The point I make repeatedly is that there’s a lot of important work to be done, people willing to do it, and an economic system that isn’t putting the two together. The U.S. is notably forgoing $1 trillion a year in added output because there isn’t enough demand in its economy.

One wants to always be careful not to over interpret any jobs report — the numbers are noisy in the monthly data. But when a number pops out that makes sense in terms of both theory and empirical evidence, it’s legitimate to take note.

In this spirit, note that the African American unemployment rate hit 6.8 percent last month, the lowest on record, with data going back to the early 1970s. In addition, the gap between black and white unemployment, measured as the black rate minus the white rate, hit 3.1 percentage points, also the lowest on record.

Now, you may well be saying, “Wait up; 6.8 percent doesn’t sound all that low, especially given that the overall jobless rate remains at a 17-year low of 4.1 percent.”

I agree. Where is it written that minority rates must be multiples of white rates? Some of the difference is due to educational differences, but not as much as you might think. Similar differentials in black/white jobless rates exist for all education levels. Racial discrimination is, of course, alive and well and in play in these gaps.

But that key observation underscores my larger point: A persistently strong macroeconomy is highly potent medicine for treating economic inequities, including racial ones. It’s not all that’s needed, by a very long shot. Purging discrimination and unequal punishment from the criminal justice, for example, is essential if we’re ever to achieve racial justice. But it’s not a coincidence that toward the end of his life, the Rev. Martin Luther King Jr. was pushing hard on a full-employment agenda.

The economics is straightforward. Discrimination — which doesn’t have to be only racial discrimination; employers might discriminate against workers who’ve, for example, been unemployed for a long time or have been out of the job market — is a “luxury” that employers who engage in it can’t afford when the economy tightens up. You either hire someone you might avoid if the labor supply queue was a lot longer, or you leave profits on the table.

So, while we shouldn’t get too excited about that relatively low monthly rate — given the high statistical variance in these data, it could jump back up next month — we should recognize and applaud these critical important macro-dynamics and the clear trends they’re delivering, as seen in the figure above.

The author of the article also co-wrote a useful book that covers the benefits and importance of full employment. It’s called Getting Back to Full Employment and can be read online for free (pdf).