Why the Fed is playing with fire when it increases interest rates

Most people think they know a thing or two about the economy. They read the news stories, take most of it at face value, and feel like they are informed.

On the other hand, economists are finding many things puzzling. The economy is not acting as it should, and they are trying to figure what is happening and what it tells us about the future.

We had 300 years to study the industrial economy and got very good at understanding how it works. That economy is gone now and the measures that we use are no longer accurate. For example, productivity used to mean workers learning to be more efficient in their jobs. Now is means the extent that robots and software replace humans.

The problem is that that the Great Recession was really the last gasp of the industrial economy. The Industrial Revolution finally sputtered to an end in 2006. Housing construction was the last labor-intensive assembly line to fall and it took the entire economy with it. Since then we have been building a new and different economy.

You’ve probably noticed some of these new truths.

Traditional jobs are harder to find. Old-fashioned 9 to 5 40 hour a week positions with fully paid health insurance are rare, but this use to be what we thought of when we saw “job announcement.”

Contingent jobs — part time/short duration jobs that do not generally provide a living wage — are replacing traditional jobs. Contingent jobs are difficult to define and count, so economists have a hard time determining their number or their effect on the labor market.

How many jobs are now contingent?

Some studies guess at around 10%, but a 2015 Government Accounting Office (GAO, 2015) report put the number at about 40% of all jobs. A very interesting report from economists Katz and Krueger (2017) summarizes a range of estimates. Interestingly they infer that about 94 percent of jobs created following the 2006–08 are contingent.

Brach and Burke (2018), researchers at the Boston Federal Reserve, think the rise in contingent work explains, at least in part, why wages are not increasing:

“Despite very low unemployment in the United States in recent months, wage inflation has remained modest. This paper investigates the possibility that there is hidden labor market slack in the form of informal or gig economy work, which may help explain this wage growth puzzle…. Together our results suggest that informal work represents an economically significant amount of potential labor supply to the formal market that may reduce pressure on measured wages.” (Abstract)

Something else that puzzles economists is a global phenomenon of entirely new labor markets springing up that are so different they defy detection and measurement. These new labor markets are things like homemakers selling cell phones on the sides of the road in Nigeria and new immigrants in many countries brokering deals between friends back home and small businesses in their new country.

Neuwirth (2011) claims that about 15% of the global economy consists of these markets.

A troubling issue growing from these trends could lead to the ruin of our new economy.

It is naturally for the economy to go through modest swings of boom and bust. When the economy slows down people are laid off, don’t have money, and cut back on buying. Demand decreases and prices may go down to compensate. As the economy improves, hiring increases, more money goes into circulation, and people start buying things. Demand increases and prices go up to capture profit.

That’s inflation.

A little bit of inflation is a good thing because it shows that the economy is healthy, with businesses making money, expanding, and hiring workers. With more money in circulation, the stock market becomes more valuable and wealth increases.

Of course, too much inflation is not a good thing. That is why the Federal Reserve has been gradually increasing interest rates. Timing and amount of increase are so essential it is often compared to a tightrope act. The Fed follows a formula called the Phillips Curve to determine when and by how much to increase rates.

The Phillips Curve is no longer working as it should, but the governors of the Federal Reserve, (presidents of the 7 largest banks), can’t just decide to fly by the seat of their pants. They need concrete reasons for making changes in something as sensitive as interest rates, and the Phillips Curve fills that need, even if it is not predicting as accurately as it once did.

Although more people have jobs they are not making much money — remember, wages are not increasing even though hiring is, and from what we saw above nobody is very sure how the new labor market works. It seems there is a hidden contingent labor market in which people work, but make very little money, putting downward pressure on wages.

In spite of all this, the Fed is modestly increasing interest rates, meaning that loans are hard to get for most people and interest rates are high. And don’t forget that wages are increasing at a fraction of interest and housing prices.

This is very troubling.

If this trend continues, it is possible for home buyers to be in such a vulnerable position that future economic shocks — increases in fuel prices, for example — would lead to widespread defaults on home mortgages.

Sound familiar?

So keep an eye on the economics, be conservative and, unless you have a very secure job or income stream, avoid big ticket purchases .

Here are some academic papers that I referenced in this article. It takes a bit of know-how to access the academic databases to download them, but if you have a buring desire to read scholarly papers written by economists I’ll be glad to send you a copy via email. vic@vicnapier.com

Brach, A., & Burke, M. A. (2018). Wage Inflation and Informal Work. Current Policy Perspectives, Federal Reserve of Boston, 18(2), 28.

Dotsey, M., Fujita, S., & Stark, T. (August 2017). Do Phillips Curves Conditionally Help To Forecast Inflation? Research Department, Federal Reserve of Philadelphia 17(26), 42.

GAO. (2015). Contingent Workforce: Size, Characteristics, Earnings, and Benefits. Retrieved from https://www.gao.gov/assets/670/669766.pdf.

Katz, L. F., & Krueger, A. B. (2017). The rise and nature of alternative work arrangements in the United States, 1995–2015 (2016). The Global Talent Competitiveness Index, 2016.

Neuwirth, R. (2011). Stealth of nations: The global rise of the informal economy. New York: Pantheon Books.