The Federal Reserve routinely uses monetary policy tools such as interest rates as a signal to stimulate employment (price stability is another goal) — but the outcomes depend on power battles in local markets.
How much power firms enjoy in labor markets can influence the transmission of monetary policy into employment and wage growth, according to a recent paper titled “Monopsony Power and the Transmission of Monetary Policy” by Federal Reserve senior economist Bence A. Bardóczy, and Wharton finance professors Gideon Bornstein and Sergio Salgado.
Salgado cited the example of an expansionary monetary policy, where the Federal Reserve lowers the federal funds rate by 25 basis points. The lower interest rate puts more money in the hands of the public, and makes it cheaper for firms to raise capital and hire more workers. When interest rates are lower, consumers save less and consumes more, increasing the demand for the output of firms.
He and his co-authors studied how two sets of firms respond to that expansionary monetary policy: high-monopsony firms, which are defined as those with a share of 10% or more of the wage bill in a market, and others with lower shares, which they described as low-monopsony firms.
They found that firms with low labor market power respond more to an expansionary monetary policy: The wage bill of low-monopsony-power firms increases by about 50% more than that at high-monopsony power firms. The study also found that oligopsonistic competition — when a few powerful buyers dominate a market — dampens the effect of monetary policy on output by 24% with lower productivity, compared to the output in a stable market.
Wielding Labor Market Power on Output and Wages
The increase in demand coming from the decline in interest rates encourages all firms in a market to hire more workers, increasing their wage bills. In that setting, firms with high monopsony power can use their market strength to hire more workers without proportionately raising wages, effectively widening the gap between what workers produce and what they are paid, Salgado said. But low-monopsony power firms don’t have that option because they lack the market heft. The upshot of that is a misallocation of resources to firms with lower productivity. “Our most important finding is how much monetary policy is less effective in the presence of labor market power,” Salgado said.
The paper identifies two distinct channels through which oligopsony dampens monetary policy. One is the partial passthrough channel, where after a monetary expansion, high-monopsony firms or those with market power do not fully raise their wages as they absorb demand shocks. Instead, they widen their markdowns, or pay their workers less relative to what those workers produce, which reduces the overall employment response. Thus, the passthrough channel dampens the wage and employment response.
The second is a misallocation channel, where employment shifts toward smaller, less productive firms, which reduces aggregate productivity, or total factor productivity (TFP). The misallocation channel reduces aggregate productivity because the employment gains disproportionately go to smaller, less productive firms.
“We are adding a new level of heterogeneity that policymakers should consider when they think about how effective their monetary policy is likely to be.”— Sergio Salgado
Salgado offered the example of the Philadelphia market for coffee, where big firms such as Starbucks and Wawa have higher labor market power than smaller brands like local roasters such as La Colombe or Ultimo Coffee. If an interest rate cut leads to a hiring spree, the smaller brands will be forced to pay more wages than their bigger counterparts to attract workers from the same pool.
“In general, the high-monopsony power firms are the big firms that are typically more productive, whereas the low-monopsony power firms are smaller and they are less productive,” Salgado said. For example, a firm like Starbucks is likely to be more productive than Ultimo Coffee, he added.
As a result, an expansionary monetary policy results in aggregate economic activity getting reallocated to the small, least productive firms in the economy, and a decline in the aggregate productivity, Salgado said.
Why Studying Local Markets Is Important
The main empirical analysis covers U.S. firms from the early 1990s to 2021, while the paper also draws on data going back to 1978 to study historical trends in labor market concentration. The model comprises approximately one million firms across 25,000 local labor markets in the U.S.
Much research has been done on how monetary policy finds its way through various sections of the economy. But one unexplored area is the role of labor market power in shaping monetary policy outcomes, according to Salgado. The paper focuses on local U.S. markets, where monetary policy affects employment, and wages are more clearly visible than at a national level.
Using that micro lens on local markets is crucial: A firm present in multiple markets may have high labor market power in one market (e.g., a grocery chain is the only supermarket in a small town), but low labor market power in a different market (e.g., the same chain but in a big city), the paper explained.
Relevant in the Present Times
The paper’s authors set out the context for their paper: Over the past four decades, local labor markets in the U.S. have become less concentrated with market shares distributed among many suppliers. Despite that decline, local labor markets are still highly concentrated, with less than 6% of the firms in a local labor market accounting for 40% of employment.
Such high concentration of labor market power can distort the outcomes of demand shocks to wages such as an expansionary monetary policy, with limited pass-through or transfer of the gains, and heterogenous responses, or variations in how firms reset their hiring and wage levels.
In recent times, the rise of mega firms such as Walmart and Amazon has raised concerns over the power they can enjoy over labor markets, Salgado said. He explained that using the coffee example he shared earlier: A small town in rural Minneapolis that had only one local coffee shop may now find itself competing with three more coffee shops from large companies.
Compared to the 1980s, today there are more firms competing at the local level for the same workers, which means the labor market power firms enjoyed has declined, he noted. Drawing from those shifting trends, “it was a natural question to study how labor market power changes the transmission of monetary policy,” he added.
According to Salgado, their paper introduces an additional factor in determining monetary policy actions. “We are adding a new level of heterogeneity that policymakers should consider when they think about how effective their monetary policy is likely to be,” he said. “If you use a model in which there is no monopsony power, you may think that monetary policy will be super effective. The answer is: not necessarily. It might be much less effective because firms have labor market power.”
