When All Else Is Out of Bounds, Zap Labor

Using its favored policy in the face of inflation, the Federal Reserve Board, under its new Chairman, Kevin Warsh, pushed up short-term interest rates in September. This action may have some impact on the rate of inflation, but probably not much. Raising interest rates may curtail inflation under some circumstances, but the major factors bringing about the current, continuing inflation are unlikely to be much affected by the Fed’s recent interest rate increases. But those other factors are out of bounds: the Fed can’t alter them, and the current administration in Washington won’t.

What Washington Has Done to Curtail Inflation

With the emergence of economic instability in the early 1970s, President Richard Nixon imposed wage-price controls that limited how much wages and prices could rise. To oversee wage-price controls, his administration established two agencies, a Pay Board and a Cost of Living Council. Economist Arnold Weber was the Executive Director of the Cost of Living Council and a member of the Pay Board. In 1974, Weber summed up the actions that these federal institutions had undertaken to contain inflation with this statement, “The goal here is to zap labor. That’s what we’re doing here…We have to zap labor.”

Attempting to quell inflation in 2022 by pushing interest rates up, then Chairman of the Federal Reserve Board Jerome Powell saw the problem this way: “…look at the average hourly earnings number we got with the last payrolls report. You don't really see much progress in terms of average hourly earnings coming down.”

Whether the mechanism was wage-price controls, raising interest rates, zapping labor, or, as Powell proclaimed, viewing “progress in terms of average hourly earnings coming down,” the authorities in Washington have been consistent in the way they have seen policy bringing about a reduction of inflation.

Since the 1970s, the favored mechanism has been for the Fed to raise interest rates. The rationale is simple: Raising interest rates makes it more costly to borrow money, and this leads both businesses and households to hold off on spending (fewer new factories, reduced housing construction, and fewer car purchases, for example). This reduction in investment lessens hiring and costs some workers their jobs. That in turn weakens the bargaining power of workers, leading to lower wages, or at least slower wage increases. As the wage bill of employers (how much employers spend on labor) grows more slowly and the buying power of workers ebbs, prices will tend to fall, or at least not rise so rapidly.

This policy has its greatest impact on workers, many of whom lose their jobs, and almost all are in a weaker position to attain wage gains. Yes, businesses can be hurt too in these circumstances. Yet, for those who make the policies, the primary problem is that wages are getting out of hand, and it is workers who will bear the burden of the policy. Moreover, the impact on labor tends to have the long-run effect of weakening the power of workers.

The most dramatic application of this anti-inflation policy took place in the early 1980s. Prices, as measured by the Consumer Price Index (CPI), rose at an annual rate of more than 10% between mid-1977 and mid-1981. By the middle of 1981, the Fed had pushed up the Federal Funds Effective Rate (FFER) to over 20%, and that rate did not fall below 10% until August 1982. (The FFER is the interest rate banks charge on overnight loans to each other, and it is the rate most immediately affected by Fed actions.) It worked. Inflation abated, running at an annual rate of less than 3% in the mid-1980s. 

And unemployment? The unemployment rate rose to 10.8% at the end of 1982, the highest monthly rate since World War II, except for some months during the pandemic of the early 2020s. And wages? The average wages for all workers fell off between the 1970s and 1980, and, for workers in the bottom half (by wage level) of the labor force, it wasn’t until the mid-1990s that wages again reached the level of the 1970s. 

Labor had been zapped.

So why won’t it work this time?

Causes of the Current Inflation

Higher interest rates tend to stop or slow inflation by reducing aggregate demand—that is, overall spending in the economy—thus curtailing employment, pushing wages down, and thereby reducing inflation. However, it is hard to blame wages for the current inflation when labor costs have not been rising as fast as prices. The Financial Times reports that the rate of labor costs per unit of output—that is, the labor cost of producing a given amount of goods and services—“over the last four years has averaged 2 percent and during the past year is running at 1.5 percent,” both of which are less than the rate of inflation. And, according to The Financial Times, “over the last 12 months, average hourly earnings have risen at the slowest pace in seven years.” Furthermore, the share of national output going to labor—that is, the portion of the economy's income paid to workers—is lower than at any time since World War II, having fallen from between 61% and 66% of gross domestic product (GDP) in the 1960s to 53% of GDP today.

In any case, important causes of the current inflation are not demand problems. Some are instead supply problems—shortages or higher costs that limit the amount of goods and services available—that have followed from the perverse policies of the Trump administration:

• The war that the U.S. initiated against Iran has had severe impacts on the price of oil and oil-based products (especially fertilizer). The high price of oil feeds through the whole economy, as is starkly seen in the way the price of diesel fuel, which was $6.51 per gallon in late September, has affected the cost of transporting goods. 
• The Trump administration’s imposition of tariffs has had an across-the-board impact on prices. Not only are the prices of the imported goods themselves raised, but much of what the United States imports is used as an input for domestically produced goods—automobiles are a well-known and important example. A less well-known example was pointed out in 2021 by The Economist: “Pfizer’s [covid] vaccine requires 280 inputs from suppliers in 19 countries. No firm can recreate that in a hurry.” Because complex international supply chains cannot be changed quickly, tariffs tend to push up the costs of many goods that are not directly affected by the tariffs.
• The massive campaign by the Trump administration to push immigrants out of the country has led to significant labor shortages in several industries—construction, meat packing, and agriculture are all examples. According to the White House, “The Trump administration has deported more than 605,000 illegal [sic] aliens, with an additional 1.9 million self-deporting, bringing the total number of illegals [sic] who have left the U.S. since President Trump returned to office to over 2.5 million.” Labor supply shortages tend to push up prices.

Not all of the factors bringing about the recent inflation are on the supply side. Yet, two important demand factors are unlikely to be substantially affected by the Fed’s effort to push up interest rates. One of these factors is the large government deficit, a consequence of large tax reductions for the wealthy without a matching decrease of spending—as cuts to programs for the poor have been offset by increases in military spending. (Not only has the Republican congress legislated tax reductions, especially for the wealthy, but there is also the failure of the IRS to halt tax evasion.) It is possible, of course, that higher interest rates, which are also increasing the costs of government debt payments, might bring some sanity to the federal budget, but this seems unlikely. Moreover, interest rates on Treasury bonds, the cost of government debt payments, are already higher than at any time in the last two decades.

The other demand factor contributing to inflation is the enormous investment in data centers being constructed to support artificial intelligence. These data centers are leading to electricity price increases in several parts of the country, and the expenditure on their construction is keeping aggregate demand strong. Of course, much of the expenditures on data centers is financed by debt, and the taking on of debt might be reduced by rising interest rates. But it seems that companies such as Meta, Amazon, Microsoft, and Alphabet (Google) are unlikely to substantially slow their activity because of interest rate hikes. For them, artificial intelligence promises the pot of gold at the end of the rainbow.

Zapping Labor

The Trump administration is very unlikely to cease its military actions in the Middle East (and elsewhere), to abandon the tariffs, or to stop pushing people out of the country—all of which affect prices by disruption of supply. And the government deficit and the massive expenditures on data centers are unlikely to be seriously affected by the Fed’s action on interest rates.

So, when all else is out of bounds, zap labor.

An Afterword

I cannot help but comment on the irony that, while progressive economists have long been critical of, and generally opposed to, the Fed using rate hikes to quell inflation, today it is President Donald Trump who is doing so with his rants for lower interest rates. 

I can defend those of us on the left by pointing out that we have opposed the supply-related policies noted above—the military actions, the inane tariffs, and the expulsion of people who have come here to work (and who pay taxes). Also, we have opposed the tax cuts for the wealthy and military spending that have fueled the inflation, and we are not at all happy with the push to build data centers. Dealing with these issues could reduce inflation without zapping labor (though electricians working on the data centers might object).

Trump, however, seems oblivious to even the existence of an inflation problem and its severe effects on the cost of living. He seems to think that the important issue is keeping interest rates low as a means of pushing economic growth and keeping the stock market booming. It appears, however, that inflation has more people (voters) agitated than slow economic growth or a possible stock market slump. 

But while I may be able to explain why progressive economists think the way we do, I make no attempt to explain the president’s thinking!                                                                                                                                                                                                                                                                                                                            

Arthur MacEwan is a professor emeritus of economics at the University of Massachusetts Boston.