The Federal Reserve is making unemployment worse and the average American poorer

The Fed's Zero Interest Rate Policies Amount To A War On Jobs

By Marc A. Miles

It is easy to conclude that Federal Reserve policy has failed.  Despite record low rates generated by massive purchases of government and mortgage back securities, economic growth is stuck below 2.5 percent and unemployment remains far from pre-recession levels.

In fact it is much worse.  The Fed’s policy has actually retarded job creation.

Fewer Job Opportunities

Understanding this perverse employment outcome requires simply understanding employers’ incentives. To expand production employers either hire more workers or invest in new machinery and technology. The decision is influenced strongly by the relative cost of the two. If the relative cost of workers falls, the employer hires more people and spends less on investments. Conversely, a higher relative cost of workers encourages slower hiring.

The investment/worker ratio has varied considerably over the last 50 years.  Each time the capital/labor ratio rises, workers on average have more capital with which to work.  Hence, the marginal productivity of workers rises.  Conversely, if the ratio falls, capital at the workers’ disposal falls and workers are less productive.

Over the last half century, the U.S. capital to worker ratio has trended upward, demonstrating that in a more prosperous country the real capital stock expands.  However, what most influences any year’s rate of job creation is precisely where the ratio is relative to that trend.  If the ratio is above the trend line, increased production uses more than the historical amount of capital and technology.  Job growth lags.  Conversely, where the ratio is below the trend line, job growth is unusually fast.

The blue line in the accompanying figure isolates the amount by which the capital to worker ratio has exceeded or fallen short of its trend line in any year.  In the late 1970s and early 1980s there was an explosion in payrolls.  As inflation and interest rates rose sharply, the capital-labor ratio fell.  By 1981 yields on 3-month T-bills reached over 15 percent and inflation exceeded 10 percent.  In order to justify capital investment, companies needed machines with a marginal productivity greater than the ever higher cost of capital.  Capital investment fell.  Simultaneously, the relative cost of workers fell, encouraging hiring.  Companies, nonprofits and government became increasingly labor-intensive.  Relatively capital-intensive industries like autos and steel found it harder to compete and contracted or even went out of business.  Relatively labor-intensive services expanded.

As interest rates trended down in the 1980s, the process slowed as more investments were profitable at lower marginal productivity.  Workers became relatively more expensive. Employers’ switched to hiring fewer workers and investing more in machinery and technology.

Recall the lament of workers in the early 1990s.  Companies became “lean and mean.”  Middle management workers became expendable.  Manufacturers found they could produce with fewer workers.  Even governments discovered that their payrolls were too high and commenced thinning ranks.  These phenomena were part of the process of raising the capital-labor ratio throughout the economy.

As interest rates continued to fall over the next two decades, the process continued.  The use of computers became increasingly common throughout the economy.  Writers learned to compose on a blank screen instead of a sheet of paper.  Computer controls began to dominate machinery.  Police relied more on devices and software instead of patrolmen and desk clerks.  The capital-labor ratio rose towards the trend line and then surpassed it.

The red line measures the average annual yield on 10-year constant maturity Treasuries.  The values are inverted to make the relationship easier to assess.  An upward movement in the red line represents a decline in interest rates, a downward move means interest rates are rising.  So rates rose sharply from the mid-1970s until 1981-82 and have mostly fallen since.

The two lines generally move together, as the theory would predict.  In recent years the continued efforts of the Federal Reserve to push interest rates lower have nudged the capital-labor ratio higher and higher.  Rates are now so low that the ratio is far above what the historical trend line would predict.

The Fed’s policy is a barrier to job creation, and hurts middle class workers.  The persistent, extremely low interest rates are dampening worker demand and keeping real wages from keeping pace with productivity. Hiring lags while wages stagnate.  No wonder unemployment stubbornly remains high, and more and more workers are simply dropping out of the labor force.  The economy may be slowly expanding, but job opportunities refuse to keep up.  The Federal Reserve is making unemployment worse and the average American poorer.