The Federal Reserve and the Job Creation Conundrum

With the Federal Reserve continuing its tightening, it is interesting to look back at the relationship between job creation and the federal funds rate, the Fed's flagship means of "controlling" the economy.

Let's start by looking at a graph from FRED which shows both the federal funds rate and the percent change in total non-farm employees on a year-over-year basis going back to the beginning of the latest expansion:

As you can see, job creation peaked at 2.27 percent on a year-over-year basis in February 2015 while the fed funds rate was at its post-Great Recession level of nearly zero (actually 0.11 percent).  As the U.S. economy anticipated a rise in interest rates, the rate of job creation began to fall and has continued to fall to a low of 1.39 percent in September 2017 as the federal funds rate has kept rising.  In fact, at the current federal funds rate of 1.51 percent, the rate of job creation on a year-over-year basis is at 1.55 percent, 0.72 percentage points or 31.7 percent below the peak experienced in February 2017.  

Let's look at previous economic expansions to see if the same relationship holds:

1.) Expansion from December 2001 to November 2007:

As interest rates rose from 1 percent to 4.59 percent, the rate of job creation grew from1.22 percent to 2.16 percent in March 2006, however, job creation rates dropped rapidly to 1.64 percent as the federal funds rate reached 5.24 percent in July 2006.  By the time that the Fed began to lower rates in July 2007, the year-over-year job creation rate had dropped to 1.11 percent, nearly half the rate at the peak in March 2006.

2.) Expansion from April 1991 to February 2001:

As interest rates fell and stabilized from April 1991 to December 1993, the rate of job creation rose from a low of -1.45 percent in mid-1991 to 2.58 percent in December 1993.  As the Fed raised rates from roughly 3 percent at the beginning of 1994 to 6.05 percent in April 1995, job creation rates rose even further, hitting a post-recession high of 3.47 percent in November 1994.  As interest rates remained at elevated levels, the job creation rate started to fall, reaching a low of 1.56 percent in January 1996.  For most of 1996 to 2000, both interest rates and job creation rates remained relatively constant, however, this changed as the Federal Reserve once again began to tighten; as interest rates rose from 5.3 percent in December 1999 to 6.53 percent in June 2000, job creation began to slow and by the time the Fed began to loosen in November/December 2000, the rate of job creation had slowed significantly, hitting a low of 0.86 percent as the 2001 recession began.

3.) Expansion from December 1982 to June 1990:

While I won't go into detail on this expansion, the relationship between rising interest rates and dropping job growth rates is still apparent, particularly after the interest rate peaks in 1984 and 1989.

4.) Expansion from April 1975 to December 1979:

Once again, the relationship between rising interest rates and dropping job growth rates is very clear, particularly from mid-1978 until the beginning of the 1980 recession.  Interest rates rose from 8.45 percent in September 1978 to 13.78 percent in December 1979 and job growth rates fell from 4.89 percent to 2.26 percent over the same time frame.

In addition, if we look at the relationship between the two economic variables, we can see that the rate of job creation since the Great Recession has been relatively modest by historical standards, despite the Fed's "heroic" measures:

That the job creation rate is already falling from relatively low levels by historical measures is certainly concerning. 

From this posting, we can see that the Federal Reserve and its use of the federal funds rate to both heat up and cool down the economy is actually quite efficient, however, there is a very heavy price to pay.  Even during economic expansions, as the Federal Reserve tightens, the rate of job growth declines, sometimes significantly.  The current expansion is no exception; job creation rates have dropped by nearly one-third since the Fed began to tighten in early 2016.  If previous trends hold, as the braintrust at the Fed continues to raise interest rates in 2018, we can expect to see the rate of job creation drop by 50 percent from the levels last seen in early 2015.  Unfortunately, central bankers don't pay the price for an economy that is creating fewer jobs as their employment is pretty much guaranteed. 

Federal Funds Rate - No Room to Manœuvre

With the Federal Reserve now telegraphing two additional benchmark interest rate increases in 2017, I wanted to take a more detailed look at one key phrase that appeared in the minutes of the Federal Open Market Committee meeting held on January 31 - February 1, 2017:

"A few participants noted that continuing to remove policy accommodation in a timely manner, potentially at an upcoming meeting, would allow the Committee greater flexibility in responding to subsequent changes in economic conditions."


What does this mean and why were "a few participants" expressing the need to have "greater flexibility in responding to subsequent changes in economic conditions."?


Obviously, in the Fed's cloistered world, the United States economy is healthy.  In their world, the labour market continues to expand, job gains are "solid", household spending was rising and inflation was still below their two percent target.  Therefore, "subsequent changes in economic conditions" can only mean a worsening of the U.S. economy, for example, the next and already overdue recession.  What the Fed participants were suggesting is that the Federal Reserve needs to raise interest rates now (while the getting is good) so that they can lower them during the next recession to stimulate the economy.

With that in mind, let's look at a table which shows the recessions since the mid-1950s, the interest rate peak just prior to the recession, the interest rate nadir after the recession and the percentage point and percent change in those rates, all using the Federal Funds Rate:

As you can see, the difference between the peak and nadir rates was generally quite substantial, in their arcane words, the Fed had significant "flexibility to respond to subsequent changes in economic conditions".  In the nine recessions since the mid-1950s, the Fed lowered interest rates between 2.83 and 10.59 percentage points with an average of 6.18 percent.


For those of you (like me) who are graphically oriented, here is a graph showing the percentage point difference between the pre- and post-recession Federal Funds rate for all nine post-1950s recessions:




Here is a graph showing the percentage decrease in the Federal Funds Rate from pre-recession peaks to post-recession nadirs:


On average, over the last nine recessions, the Fed lowered their benchmark rate be between 48.7 percent and 97.1 percent with an average drop of 69.9 percent.  The Great Recession saw the largest percentage drop at 97.1 percent, giving us a sense of how desperate the economic situation had become.


With the Federal Reserve's benchmark Federal Funds rate currently hovering at just under 0.70 percent, even if the Fed does boost rates by another 50 basis points this year, as the data in this posting shows, they have manoeuvred themselves into a policy corner which will make it extremely difficult to achieve any meaningful monetary policy response to "subsequent changes in economic conditions".  My suspicion is that the Federal Reserve's lack of interest rate maneuverability will force them into implementing a European-style negative interest rate policy along with significant asset purchases (i.e. QE 4, 5, 6...ad infinitum) in a desperate attempt to revive a recession-bound economy.