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There are big changes happening in business that are not visible on the front pages of newspapers. It has to do with the ground cost of capital in the economy, and some of its biggest impacts will probably be on the labor market and how businesses use it.
What economists call the “real interest rate” changes: the underlying cost of borrowing after taking inflation into account. In most developing economies, the real rate of interest is positive as there is a concrete return to investing in recent capital. But for years, the U.S. real rate of interest was near zero – even negative – as the Fed pumped trillions of dollars into credit markets.
Those days are gone. Even with rates of interest unchanged, the Fed continues to withdraw money from credit markets sale of long-term securities. At the same time, governments around the world are holding on historically high debt levels, a large component of credit demand. Together, these aspects make it difficult for businesses to acquire financing.
The Fed’s latest estimates show that the real rate of interest for 10-year protected securities increased by almost 2% after hovering around 0.5% before the Covid-19 pandemic. The actual rate of interest that companies must pay to take out a loan starts with this 2% number and adds inflation to it. So with inflation at 3% – where the economy currently appears to be stuck – the total rate will probably be at least 5%. And that is only for the safest borrowers; growing companies will have to pay more.
Despite the Fed’s best efforts, inflation is expected to persist barely above goal level of two% for the next few years. So unless the real rate of interest falls, companies that borrow to lift capital can expect to pay high rates for an prolonged time period. Here’s what this might mean for the way they do business.
More work, less capital
The rise in the real rate of interest makes capital – productive products comparable to buildings, machinery and computers – relatively costlier than labor. In response, companies are more likely to change the mixture of inputs used to supply goods and services. Especially developing companies will probably be more willing to employ and less more likely to take out loans. Businesses that do not grow can slow staff loss. With greater demand for labor in a market that is still tight by historical standards, staff may regain some of the bargaining power they have gained over the past 12 months or two.
Automation paused
As inputs grow to be more labor-oriented, trends in production processes may even change. Progress towards greater automation in each manufacturing and services will probably be slower, all other things being equal, as will the implementation of recent technologies comparable to artificial intelligence. Automation has been an essential long-term play for companies struggling with labor shortages over the past few years. For companies considering this feature, it could be much costlier now.
Slower wage growth
If companies invest less in recent capital, their employees will have less productive things to do. As a result, their productivity won’t grow as quickly. So while higher labor demand may increase wages, the economic fundamentals that drive wages higher in real terms over long periods could also be weaker. Overall, the economy may have lower unemployment but without the rapid wage growth that is often associated with a tight labor market.
Greater employment stability
Real rates of interest are normally high is associated with a higher savings rate. When people and businesses have more savings, they’ll more easily weather economic and financial shocks. There is also some evidence for this prices are less volatile when real rates of interest are higher. The coming years may due to this fact be barely more stable, at least to the extent that the economy is driven by fundamentals somewhat than external shocks.
This will probably be a welcome change for the labor market, which is finally finding a measure of stability after the dramatic fluctuations of the pandemic. A volatile economic cycle means high hiring and firing rates, in addition to increased recruitment costs, additional production frictions, and lower investment in training and employer-employee relationships. If the economic cycle calms down, these negatives will turn into positives.
All of those trends will occur concurrently and may reinforce or counteract each other before the economy reaches a recent equilibrium. (Who said economics is easy?) But the overall trend is quite clear: more emphasis on work in a more stable, though perhaps less dynamic, labor market. After a wild ride over the last few years, this is something employees may very well welcome.
When it involves businesses, people who have to borrow to lift capital should want to reconsider some of their plans. Relying more on work and less on technology may look like a step backwards, but it doesn’t have to be; recent and cost-effective worker tools like generative AI can offer the better of each worlds. Companies can at least benefit from the stability of the labor market by making deeper investments in staff who will stay longer.