Fed policy is heading into trouble
The future of monetary policy is troubling. I present a video to explain. (Part 4 of a series on the journey of the Fed rate from 1978 to the present.)
Since the 1960’s, the Fed rate has consistently reacted to the natural level of real GDP (in terms of labor and capital utilization). Effective demand sets the natural level. The natural level of real GDP has fallen since the crisis. Monetary policy so far does not recognize this. This graph from the video shows how the natural level of real GDP is determined.
There are 3 red trend lines. The point where each trend line crosses the x-axis sets the natural level of real GDP (in terms of labor and capital utilization). The trend line on the right is from the 1970’s to 2003. The trend line in the center is from 2003 to the crisis. The trend line on the left points to the current natural level of real GDP. The Fed funds rate has recognized and responded to these levels consistently over the years. The trend line shifts with core shifts in labor share.
A problem is that the Fed along with other economists, like Paul Krugman and Larry Summers, still see a large output gap to bring the economy back to full employment. In effect, they still see the economy returning to the middle trend line above, but with a negative real rate to get us there. As Larry Summers said yesterday, “Indeed, US real rates are substantially negative at a five year horizon.”
The natural real interest rate at full employment is roughly determined by adding productivity growth, population growth and a time preference variable. As people put off consumption into the future, the time preference variable declines. Productivity growth is low, population growth is low and people are preferring to consume less currently. So it might seem reasonable that the natural real interest rate has fallen from its historic range of around 3%.
But has the natural real interest rate gone negative? No… It should be positive when the natural level of real GDP is reached in about a year, but not quite as high as 3%. In the video, I say 1.5%. Pimco said that the Fed forecasts reaching its target with a 2% natural real rate by 2019! Well, we won’t have to wait that long.
Note: In the video, I say there is price stabilization when the natural real interest rate and the current real interest rate curves cross under the Fed rate. This concept is related to the neutral real interest rate, which is defined as monetary policy which is neither expansionary nor contractionary. (Bernhardsen 2007, Wu 2005)
Related sources…
Bernhardsen, Tom, Karsten Gerdrup. The Neutral Real Interest Rate. Monetary Policy Department, Norges Bank. 2007.
Escolano, Julio, Anna Shabunina and Jaejoon Woo. The Puzzle of Persistently Negative Interest Rate-Growth Differentials: Financial Repression or Income Catch-up? IMF working paper. November 2011.
Collignon, Stefan. Implications of the Low Interest Rate Environment for the Real Economy. European Parliament. Draft paper. February 2013.
Lambert, Edward. Series of videos on the Journey of the Fed rate. Part 1 (1978 to 1988)… part 2 (1988 to 1997)… part 3 (1997 to 2008). Youtube.com. December 2013
Summers, Lawrence. Why stagnation might prove to be the new normal. larrysummers.com. December 15, 2013.
Wu, Tao. Estimating the “Neutral” Real Interest Rate in Real Time. Federal Reserve Bank of San Francisco. October 2005.
A background question: “The trend line shifts with core shifts in labor share” – I don’t see why the shifts are quantized. Seems like the shifts would be gradual, rather than taking discrete jumps.
Fred,
You are astute. I wondered who might catch that thought. You are obviously thinking.
When the line in the graph above slants downward toward the x-axis, labor share is changing a lot. So as you say, there were gradual shifts. Yet the TFUR (labor and capital utilization) is changing right along with it. It stayed that way for decades. The “interest rate” measure of that relationship was stable. Then after the 2001 recession, the relationship shifted. It shifted again after the crisis.
A core dynamic in the relationship between labor share and TFUR shifted.
I really doubt that anybody saw another thing. The slope of the LRAS line is the same as the lines in the second graph above. You can compare the two images above.
The issue starts to get deep beyond this point. A good point to sit down with some good food and drink and have a discussion. Yet, not being able to do that, we can discuss here.
First, the TFUR moves up and down within a range.
Second, labor share will maintain a somewhat linear relationship to it as shown by the interest rate measure.
Third, effective demand itself is going through large changes up and down. And effective demand is a function of the same variables, labor share and TFUR.
Fourth, a shift is definitely to the left, not down. The range of the TFUR shifts left to a lower range on the x-axis.
Fifth, labor share is the limiting factor on the TFUR range.
Sixth, thus the shift is due to a core shift in labor share. If the shift was due to TFUR shifting down, the line would simply slide up the existing line. So labor share has to shift to shift the line.
What is a core shift in labor share? If you look at where the shift occurs, you will see it happens during a recession, when businesses are cleaning out labor and capital. At those times, businesses are able to re-construct labor share, as they re-hire on workers. In the last two recessions, businesses made a conscious choice to lower labor share. Most likely in response to price pressures from imports.
Once the business cycle starts to recover, businesses have already set the standard for pay and labor share. Then the business cycle proceeds with that in place, and it becomes difficult to change the standard.
This means that shifts in labor share must happen during recessions.
The conclusion is that labor share cannot just be raised once the business cycle gets going. Businesses have already laid the path of it as the recession fades away.
So…. if we were to try and raise labor share in the future, would the best time be during a recession? That is difficult, because labor loses most of its power then.
So then, is it possible to raise labor share in the expansionary phase of the business cycle? Yes, but the effort and the effects on business are great.
So when will labor share rise? Really, the better question is whether it will fall even more during the next recession.
In summary, there is pressure to lower labor share from import prices. Labor share falls during recessions as businesses clean out labor and wages. Yet, labor share can only fall so fast during a recession. There are limitations of time and rigidities. There is probably still some pressure to lower labor share even more, and that adjustment now has to wait for the next recession.
Take a sip and let me know your thoughts on that…