Why Low Interest Rates Are Ineffective

It is becoming increasingly apparent that the Federal Reserve will have to be even more creative during the next economic slowdown since the effectiveness of its monetary policies since the Great Recession seem to be wearing off as the economy, both domestically and globally, seems to be weakening.  As well, there are factors at play that have, over the past three decades, resulted in subdued economic growth as you can see on this graphic:

As you can see from the red line, the trend in real GDP growth has dropped rather significantly since 1980.  Since 1980, the average annual real GDP growth rate was 2.61 percent when both contractions and expansions are included; by comparison, the average annual real GDP growth rate since the Great Recession was only 1.3 percent when both contractions and expansions are included.

Why is this?  A recent article by Frank Shostak and Peter Stellios on the Mises website looks at why the Fed's current low interest rate policy is not creating economic growth.  First, they look at how productivity has declined over the past three decades as shown here, focusing on how the curve has flattened since 2009:

Even worse, the year-over-year growth in real output per hour since the end of the Great Recession (excluding 2009 and early 2010) is the lowest it has been during an economic expansion since 1980:

As well, the year-over-year growth in real private non-residential fixed investment has dropped substantially since 2012 as shown here:

It is important to keep in mind that the Federal Reserve has actively been propping up the American economy over the past three years while the growth in investment has dropped.  One would think that the continued policy of low interest rates would be encouraging growth in private investment not the other way around.  Obviously, there is another mechanism at work.  Please bear with me, some of this theory is rather abstract and flies directly in the face of traditional monetary theory which believes that interest rates drive consumption and that more aggressive monetary polices result in greater levels of economic growth.

The authors of the article note that "economic growth requires more than just low interest rates.".  The Austrian business cycle theory states that business cycles are a consequence of excessive growth in bank credit due to artificially low interest rates that are set by central banks.  As well, Austrian business cycle theory also examines the role that central banks play in the growth of the supply of money and how loose monetary policies impact the process of both wealth formation and the accumulation of real wealth.  In a market economy, money serves as a medium of exchange which allows the product of one producer to be exchanged for the product of another producer.  Here is a quote from the authors:

"The exchange of something for something also means that consumption doesn’t precede production. That is, we first have to produce a useful product before it can be exchanged for money and only then we could exchange money for goods we desire. Consumption is fully funded by preceding production."

The effects of easy money are set in motion by loose monetary policies like those currently being adopted by the Federal Reserve.  As the money supply increases, the process of transferring wealth from the wealth generators to the holders of the new money that was created out of thin air meaning that there is an exchange of nothing for something.  Here is another quote from the authors:

"This means the holders of newly printed money have taken from the pool of real wealth without giving anything back in return.  Consequently, this puts pressure on the pool of real wealth. Similarly to government, these holders of newly created money are engaged in non-wealth generating activities. (These activities sprang up on the back of money pumping. In the free unhampered environment these activities, which ranked as low priority would not be undertaken.)

Again loose monetary policy undermines the process of wealth generation and weakens the pool of real wealth.

One could however, argue that any form of investment takes from the pool of wealth without giving anything in return in the short term. This is true; hence if the present flow of production of final consumer goods is not fast enough, then the pool of wealth is going to come under pressure in the short term.

In the case of productive investments, one should expect in the future a strengthening in the pool of wealth. This is, however, not the case with respect to non-productive investments." (my bold)

Basically as the pool of real wealth weakens, it becomes much harder for businesses to continuously increase the pace of investment and, in turn, the pace of productivity growth drops.

Let's look at a graphic showing how the Austrian School measures the increase in U.S. money supply:

The Austrian definition of the supply of money (AMS) is as follows:

"Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods and services on the market."

Accordingly, AMS stood at $1.47 billion in 1960, rising to $4400 billion in mid-2016, an increase of 2283 percent and 188 percent since Q1 2000 alone.  This massive "printing" of money has created significant downward pressure on the wealth generation process.  It is this downward pressure on the pool of real wealth that has resulted in an increase in the time preferences of individuals, that is, their preference toward present consumption increases when compared to their preference for future consumption which puts upward pressure on interest rates as we can see in this graphic showing the real interest rates on AAA-rated corporate bonds and how they rose after 1980:

  

Between 1959 and 1979, the AAA real corporate bond yields averaged 1.98 percent compared to 4.26 percent between 1980 and mid-2016.  This does suggest that the pool of real wealth since 1980 has been under pressure.

Here is the authors' conclusion:

"We can only suggest that notwithstanding loose monetary policy, the wealth generating private sector has managed to create wealth, however as time went by on account of massive money pumping, their ability to keep the pool of wealth growing at an expanding pace has likely been curtailed.

To conclude we can suggest that contrary to popular thinking loose monetary policy cannot grow an economy but it definitely can destroy it and in this sense it is very potent." (my bold)

While many people don't particularly subscribe to the Austrian school of economics, their rejection of the classical view which states that interest rates are determined by the supply and demand of capital rather than the subjective decision of individuals to spend money now or in the future appears to go a long way to explaining why the Federal Reserve's interest rate policies are basically ineffective. The Austrian school's belief that business cycles are created by distortion in interest rates due to the actions of central banks and governments to control the supply of money flies in the face of what classical economics would suggest and may help us to better understand why this economic expansion is one of the least vigorous in decades.

Fair Wages for Hard Work? Not in America

An analysis by Josh Bivens at the Center on Budget and Policy Priorities looks at the connection between wages and inflation.  The strong link between interest rates and price inflation is through the mechanism of wage increases which are spurred by tightness in the labor market.  By increasing short-term interest rates, the pace of economic activity is lowered, reducing the pace of declines in unemployment which reduces the ability of workers' to bargain for higher wages which, in turn, reduces the pressure on inflation.  Mr. Bivens observes that, since wage inflation and not slackness in the labor market is the most significant intermediate link between interest rate increases and lower price inflation, the brilliant minds at the Federal Reserve should focus on wage inflation as an indicator of where interest rates should head.  With the Federal Reserve contemplating a move toward tightening after their prolonged experiment with zero interest rates because of improvements in the headline unemployment rate, perhaps they need to take a closer look at what has happened to nominal wages to determine their future policies.

As has become apparent, the traditional measures of economic health, particularly the headline U-3 unemployment rate have become particularly useless indicator of economic health since the labor force participation rate, at 62.5 percent, is depressed to levels not seen since the late 1970s as shown on this graph:

Other economic measures like estimates of the natural rate of unemployment which is the rate below which inflationary pressures will increase are subject to large margins of error and are not suitable for determining monetary policies.

As we've noted, since late 2010, the unemployment rate has fallen steadily yet, inflation has remained tame as shown on this graph:

This is telling us that even though unemployment dropped from 10 percent in 2010 to approximately 5.5. percent in mid-2015, inflation has not reared its ugly, frightening (to central bankers) head.  Conventional wisdom would tell us that inflation should be much higher than it is given that unemployment has nearly halved and that there should be significant upward pressure on wages.  Unfortunately for those of us who work for a living, this graph that shows what has happened to nominal wages and unemployment since 2006 is particularly sobering:

Economists like to use the Phillips curve which plots the percentage change in inflation (or nominal wages since the two are closely connected to each other) against the level of unemployment which looks like this for the 1960s:

As you can see, at high levels of unemployment, inflation/wage increases are low.  In the 1960s, as the economy moved from 6.5 percent unemployment to 5.5 percent unemployment, inflation/wages rose by a less than one-half percent.  When the economy moved from 4 percent unemployment to 3.5 percent unemployment, inflation/wages rose by more than a percent.  As unemployment decreases, inflation/wage increases begin to rise at a faster rate.  This is not the case now; as the graph above shows, at 5.5 percent unemployment, the inflation rate/rate of nominal average wage increases is far, far lower than most economists would predict using the Phillips curve.

Now, let's switch gears and look at another measure of economic health, productivity, a measure that will help us set a wage target.  First, here's a rule of thumb from the paper:

"...as long as nominal wages are growing at or beneath the rate of productivity growth, then labor costs are putting no upward pressure on prices at all. This concept is embodied in unit labor costs, i.e., the unit of compensation per unit of productivity. If real wages and productivity accelerate by equal amounts (in percentage terms), there is no increase in unit labor costs and no pressure on prices from wage growth, as more efficient production (faster productivity growth) has “absorbed” the wage increase such that it does not need to be passed through to prices.

For small magnitudes, the change in unit labor costs can be approximated as the percentage change in hourly pay minus the percentage change in productivity. And this change is what the Fed is hoping to keep running below its target rate of overall price inflation. So long as unit labor costs are rising at less than 2 percent, they are not putting upward pressure on the price inflation target."

Obviously, changes in worker compensation are closely connected to the growth rate of productivity.  Here is a graph showing the total growth in net economy-wide average annual changes in productivity over 12, 24 and 60 month-long cycles between 1995 and 2014:

Productivity growth over the cycle between 2001 and 2007 averaged 2.1 percent and over the four cycles between 1973 and 2007, it averaged 1.5 percent.  The author feels that range of 1.5 to 2.0 percent is reasonable.  Therefore, if we sum changes in productivity at 1.5 percent to 2.0 percent and  accompany it with inflation at 2.0 percent (the Federal Reserve's target rate), then hourly compensation growth of between 3.5 and 4.0 percent should not cause a problem.  That said, as shown on this graph, the year-over-year change in nominal average hourly earnings of American workers since 2007 has been well below the minimum wage-growth target (shaded grey):

As you can see, hourly wage growth has been between 1.5 and 2.5 percent since 2009, well below the wage-growth target.  This extremely low level of wage growth makes us wonder why inflation hasn't been even lower than it is.  Here's the fly in the ointment:

All of the growth in prices since the second quarter of 2009 can be accounted for by rising profits (light blue bars) due to increases in markups over costs.  Unit labor costs have been flat and all other costs have actually declined but unit profits on a pre-tax basis have increased by 7.6 percent annually.  This growth in unit profits are responsible for 64 percent of the rise in prices since the last business cycle peak in the last quarter of 2007.

This is why the labor share of corporate sector income has done this since the early 1980s:

With nominal wage growth of 4 percent, it would take until 2029 to attain the pre-Great Recession labor share of corporate sector income of 79.4 percent in Q4 2007.  Using the same 2 percent inflation numbers and 1.5 percent trend productivity growth as before, with nominal wage growth of 4.5 percent, it will take until 2022 and with 5 percent nominal wage growth, it will take until 2019 to attain the pre-Great Recession labor share of profits as shown on this graphic:

Despite the fact that we are now seven years past the trough of the Great Recession, we are still seeing very little improvement in the wages of American workers.  Wages are still growing at levels that are well below the non-inflationary wage-growth target levels of between 3.5 and 4.0 percent.  Rather than sharing the benefits gleaned from increasing worker productivity since the Great Recession, Corporate America is choosing to pad its bottom line, explaining why inflationary pressures have been far lower than we would normally expect.