Tim Duy, who is a cool economist, points out a difference between the labor market and output GDP… Labor market improving while GDP is slowing. He describes this difference for the Fed.
“Now they have slow GDP growth and fast employment growth. That will make brains explode on Constitution Ave.”
Yet, Brains need not explode. I have had a model of this difference for a couple of years, which predicted perfectly this situation. Yet, my model ultimately shows that the business cycle has ended, which is something economists like Duy and others at the Fed may not accept.
The Cobra Equation
The driving force behind an effective demand limit is the aggregate profit rate. When companies have increasing profit rates, it is more difficult to have a recession. We have seen in the past year that the aggregate profit rate is falling. This is not a good time to be raising interest rates. It would have been better a few years ago. Anyway…
I gauge aggregate profit rates in 3-dimensional space with what I call the Cobra equation, because it resembles a cobra in 3-D space…
Profit rate = (U + C) – a*(U2 * C2)
U = (1 – unemployment rate)
C = Capacity utilization
a = effective labor share2 – 2.475 * effective labor share + 2
When I take the derivative of the equation, I can gauge the potential change of the aggregate profit rates. I can take the derivative with respect to C and U.
d profit rate/dC = (1 – 2aCU2)
d profit rate/dU = (1 – 2aUC2)
They look the same but in reality they take different paths. Here are the derivatives up to December 2015.
Basically the graph shows that the utilization of capital reached its max profitability towards the end of 2014, when the red line reached zero %. Businesses have squeezed all they can from capital in the aggregate. For capital, the business cycle is over. But hiring labor is still profitable, so as the business cycle hangs on, we will see improvements in the labor market.
This model predicted perfectly the path of utilizing labor and capital. Here is a graph plotting the Cobra equation. The utilizations of labor and capital reached profit maximization, slid along the max limit, and have since backed off which is setting the stage for a recession type scenario.
The Greater Meaning
The greater meaning behind this model is that the economy has already reached the top of the business cycle and the Fed is completely behind the curve for raising the Fed rate now. They should have been normalizing the rate before the plot in the above graph reached the effective demand limit. The economy had momentum at that point to withstand interest rate rises… but not now.
The Fed should stop trying to raise the Fed rate and just let the business cycle collapse on its own. The Fed is just hastening the recession process by projecting rate increases beyond the effective demand limit.
The Fed is really messed up because they do not have a “real-time self-calibrating” measure of an aggregate effective demand limit. But we have one here… so brains need not explode. However, brains may explode once the Fed realizes they are completely behind the curve.
Update: A bit to add about slowing GDP…
This goes back to the equation for profit rate…
Profit rate = (Productivity – Real compensation) * Total labor hours/Capital stock
Increasing labor hours increases the profit rate. Whereas increasing the capital stock would tend to decrease profit rates. So when capital is maxing its use in the aggregate, we will see an aggregate drop in capital investment, which is the current driver of slowing GDP.