Mark Thoma wrote today that the Fed should not raise rates too soon, because…
“If the Fed raises rates too soon, it is working class households who will be hurt the most by the slower recovery of employment.”
His thinking is not deep enough. He just sees that a rise in the Fed rate will slow down the “recovery” and thus less workers will be employed. But we are in the end phase of the business cycle. So let’s unpack why unemployment is falling.
Let’s look at a modified equation of profit rates.
Profit rate = (Productivity – Real compensation) * Total labor hours/Capital stock
Modified Profit rate = Capital share of income * Total labor hours/Capital stock
The difference between productivity and real compensation is the share of productivity that goes to capital.
Aggregate profit rates have not been rising. There is concern that they are vulnerable to falling. So why have profit rates not been rising? First, labor share is starting to tick slightly upward after its great decline after the crisis, which means capital share is ticking downward. There are pressures to raise real wages. Profit rates will decline under this scenario. However, second, Total labor hours have been accelerating in 2014, which has the effect to offset the effect of a slightly declining capital share. (link) Third, investment will need to be moderate. (link)
My point is that unemployment is falling not because the economy is recovering, but because the profit rates of firms are becoming vulnerable.
How is this different? Well, the recovery is over for firms. Profits and stock indexes are already at record levels. Firms must protect their profit rates or the stock market will decline. And yes, we see how sensitive the stock market is to news from the Fed about rates. When rates start to rise, the cost of capital stock will rise which will hurt profit rates. Many firms on the margin will have problems which could make other firms marginal.
However, as firms try to increase Total labor hours, the risk of higher real compensation to attract more workers also increases. The profit rate declines as a result. A low inflation rate is good protection against having to raise real compensation. So there is a desire by capitalists to keep inflation low.
The Logic Driving Low Fed Rates
The Fed is not going to raise rates any time soon. Firms are hiring to protect their profit rates, but that game will come to an end with pressures to raise real compensation. Firms are too vulnerable to a decline in profit rates. Who increases those pressures? Labor itself. There are many unemployed workers, and employed workers, who require more compensation.
So firms are not only vulnerable to a rise in the Fed rate, but also to wage demands. One or the other will eventually undermine vulnerable profit rates. And when profit rates start declining and higher real compensation makes increasing total labor hours unprofitable, employment will stop its “recovery”, as Mark Thoma puts it. In reality, firms will stop their efforts to protect their high profits due to labor being expensive.
Firms are fine hiring now as long as real compensation does not increase. Firms really are vulnerable in their desire to maintain record profit rates.
Again… The Fed will not be able to raise rates any time soon. They waited too long. The momentum of increasing profit rates subsided over a year ago. The Fed’s window of opportunity to normalize policy rates ended at that point. Now firms are too vulnerable. Firms have become accustomed to the low standards of accommodative monetary policy. So the low Fed rate is now normal policy for many inefficient firms, which the banks are protecting.
Raising the Fed rate now would be like raising a normal Fed rate. The Fed has put itself into a trap that the ZLB is pretty much normal policy standards for the economy. Firms have asymptotically aligned their efficiencies with the ZLB over 5 years. And we will have the ZLB for at least another year. Inflation has aligned itself with the ZLB through the Fisher Effect too.
Increasing Real Compensation vs. Pent up Need to Save
It is hoped by many economists that real compensation will increase. Tim Duy sees a 6.1% unemployment as the level at which real compensation will start to increase. But will it? Can it? How much of a rise in real compensation can profit rates withstand? Can a rise in real compensation be offset by raising output prices? How strong is the demand constraint upon prices? Even if people earn more, they have developed strong habits of buying at cheaper prices.
So if prices are not able to compensate for a rise in real compensation, real compensation will not rise much. In decades past, demand potential was stronger. Moreover, labor had more wealth to back up consumption. But not now. Labor’s wealth has been eroded. They need to spend very carefully and try to save. Even Janet Yellen in a recent speech said that middle and low incomes need to save more. And they want to. These incomes want to increase their savings. So if you pay them more, demand for finished goods and services will not increase as much as it did in times past, because of a pent up need to save.
So if the Fed raises rates, people will gladly increase their propensity to save which will suppress demand, profit rates and employment. But even if the Fed does not raise rates, the increase in real compensation has strong limitations due to underlying frailties of profit rates. Labor has little to gain irregardless of what the Fed does.
The past 5 years of the Fed rate at the ZLB has established a new normal. The Fed rate will have to be near the ZLB for a long time to come. Firms have built their business plans and efficiency around the ZLB. It is a fantasy to think that the Fed rate might start normalizing soon. It is too late for that. The zone of the ZLB has become a new normal. The Fed does not want to trigger a contraction with profit rates of firms being so vulnerable.
Labor has severe disadvantages in the present situation. There are dynamics and pressures to push compensation down. There are dynamics to make labor consume instead of save to support profits. In the end, labor is falling further and further behind economically, whether or not the Fed raises rates.
Consequently the US economy will be at a socially sub-optimum level for years and years to come. A few have been made better off at the expense of many.