An Effective Demand theory of the Fed Rate through the Business Cycle

In time, we will see a debate start raging as to whether the Fed rate should have started rising earlier instead of at the end of 2015. Some like me say that the Fed rate should have started rising earlier because the market had momentum and the capacity to accept the rate rises. Others say the market had to wait to tighten the labor market more and try to generate some inflation.

A Theory of the Fed Rate Movements based on Effective Demand

A measure of the effective demand limit gives a view of spare capacity in the economy through the business cycle.

The plot shows spare capacity in the economy in terms of labor and capital. The plot in the graph above expands upward during a recession, then contracts downward through a business cycle.  When the plot is high, there is more spare capacity that can be utilized and the Fed rate should be lower than its normalized rate.

How could the Fed rate change in relation to this graph?

The Fed rate would fall during a recession as spare capacity rises. Then as spare capacity gets utilized, the Fed rate should start rising again toward its neutral natural rate. In theory, the Fed rate would ideally normalize when the plot reaches near zero.

The Fed rate would change something very roughly like this… (range is 5% normalized Fed rate which falls to around 2% during a recession)

The Fed rate would fall during a recession and when spare capacity is rising. The Fed rate would rise when spare capacity falls to around 5% on graph until it reaches a 5% normalized rate when the blue plot reaches near zero.

How well has the actual Fed rate followed this pattern?

Compare how the brown and red lines move up and down together. The two lines do seem to move together roughly at the same times. So the Fed rate has already followed the pattern. (link to FRED data)

Note… The Fed rate should not have risen before the 2001 recession when the spare capacity was actually rising.

A Graph for a Theory of the Fed Rate through the Biz Cycle

Basically a theory would say that the Fed rate should start rising when the plot is falling between the red lines. Once the plot goes below the red lines, the Fed rate should not rise, but stay steady and be ready to come down to preserve the natural level of full employment. Then the Fed rate should come down when the plot is rising above the lower red line.

According to this simple theoretical model, the Fed rate should have started rising moderately back in 2012 or 2013 (update: assuming a normalized Fed rate of 3% to 4%). And now is not the time for the Fed rate to start rising toward a normalized natural rate since the plot has already bottomed out. A rising Fed rate now will eventually strangle the economy which has very little spare capacity.

I use this theory to say that the Fed should have started raising the Fed rate moderately earlier in the recovery.