No Con Economics

“Cheap money can’t buy a strong economy” – R. Samuelson

This posting argues that the monetary policy implemented by the Federal Reserve has limited influence on the level of employment in the economy.  First, here’s some background.

A few years ago, Mohammed El-Erian, author of The Only Game in Town, argued that pressure was being put on the Federal Reserve Bank (FED) because other macroeconomic stabilization organizations (Congress and the executive branch) were incapable or unwilling to act to either bring down inflation or stimulate economic growth. He observed that the FED is (largely) independent of contemporary political forces; so, it could use its (limited) power to stabilize the US economy and allow the other branches of government to escape the political costs of the choices they make.

The Federal Reserve Act of 1913 established the FED as an agency independent of the executive branch of government.  The FED, however, is not independent of Congressional action as reflected by amendments to the Federal Reserve Act (FRA) instituted in 1917, 1927, 1933, 1977, 2010, and 2018 . Some of these changes (e.g., 1933, 1977, and 2010) were major.  The point remains that Congress can change the role of the FED, or even eliminate it, for political or other reasons.

Perhaps a more important point is that monetary policy conducted by the Open Market Committee of the FED has very limited tools: changing the target for the federal funds rate (ffr), the lending rate for overnight fund transfer from one member bank to another, is its primary tool.  Prior to the Great Recession (2008-2010), the FED would use open market operations (the purchase and sale of short-term Treasuries) to influence the ffr.  In the last decade and a half, an era of abundant excess reserves held by banks on which they are paid interest as determined by the FED, the FED has directly set the ffr target and often adjusts the interest rate on reserves in conjunction with that target.  Given the 1977 amendments to the FRA, the FED is often described as having a dual mandate: to generate both price stability and maximum employment.

There is plenty of debate about how price stability and maximum employment are defined and measured, but that’s not my concern here.  When there are shocks to the aggregate supply of goods and services, the FED has to choose which of its two mandates to satisfy or attempt a balance of some sort between the two.  As FED chair Jerome Powell recently said “There is no risk-free path”. John Taylor has argued that the FED has historically attempted to give equal weight to these two mandates.  He showed that the FED has historically increased the ffr when inflation is above its target and decreased the ffr when the level of unemployment is above its full employment rate. 

Alas, now I have reached the point I would like to emphasize. Despite Congress’s desired dual mandate, the FED’s ability to influence employment is rather limited.  To the degree that the FED chooses to lower its target fed funds rate, it may stimulate purchases, but these won’t necessarily result in increases in employment.

Now, it’s time to become a bit technical.  In particular, consider the concept of the elasticity of substitution between factors of production (sigma).  This calculation indicates how much the ratio of labor to capital changes when the ratio of the cost of labor changes relative to the cost of capital.  According to a 2020 article in the Journal of Economic Surveys , in which the authors observed the results from 852 estimates of sigma published between 1961 and 2017, the vast majority of results were between -0.3 and -0.7.

For example, a sigma of -0.5 suggests that a 10% increase in the cost of labor relative to the cost of capital would yield a 5% decline in the amount labor employed relative to capital. To put this in contemporary context, the cost of labor is rising as both wages and the cost of benefits (health insurance in particular) are rising and many potential workers have left the market (of their own accord or as a result of immigration policies.)  A decline in interest rates, if changes in short term treasuries lead to changes in long term commercial rates, would reduce the cost of capital.  Thus, the indicated rise in the cost of labor relative to the cost of capital would generate a decline in the labor/capital ratio. Such a result might arise from an increased purchase of non-labor factors of production, a decrease in the quantity of labor employed or both.

In March 2016, I presented a paper entitled “Employment in Manufacturing and Monetary Policy: Cyclical and Structural Factors” at an International Atlantic Economic Society conference in Lisbon, Portugal.  Based on several different manufacturing sector regression equations, I observed that loosened monetary policy (through reduced interest rate targets) along with uncertainty regarding the prospective cost of labor provided reasons to substitute capital (especially equipment and software) for labor.

Bottom line: In the current macroeconomic environment, a decline in the federal funds rate implemented by the FED, may have little or even negative effects on the level of employment.  Magnitudes matter here, especially, given the significant changes in those factors that influence the labor market.  These factors, such as labor participation rates and health insurance premium rates, are largely outside the bounds of the FED’s monetary policy powers. Employment can be much more strongly influenced by fiscal, immigration, and regulatory policies than by monetary policy.

In short, “the only game in town” may have few cards to play that can stabilize the U.S. economy given existent actions taken by Congress and the President.