# The Inflation game (part 2 and wonkish)

Whereas David Romer will say that the low inflation rate is a result of the zero lower bound. I would say that BOTH the low inflation rate and the zero lower bound result from the weak consumer liqudity due to very low labor share.

In the previous post, I wrote about how inflation is a game of cat and mouse between the prowess of consumers’ liquidity and firms’ prowess to manage products and prices. I presented the equation for inflation’s tendency to rise or fall…

Inflation tendency = liquidity prowess of consumer dollars/production prowess of firms

• If the numerator and denominator are equal, then inflation will be constant. (Equal inflation tendency = 1)
• If liquidity power of consumers is stronger, then inflation will tend to rise. (Positive inflation tendency > 1)
• If production prowess of firms is stronger, then inflation will tend to go lower. (Negative inflation tendency < 1)

I want to go deeper into what shapes inflation. I will refer to this equation during the post, but first, a look at inflationary gaps.

Inflationary gaps define the top side of a business cycle, when real GDP is closer to its natural limit determined by the effective demand limit. It is called the inflationary gap because inflation was seen to occur with it, or at least that’s the way it was in the past. In the effective demand research, the inflationary gap occurs when capacity utilization is more than effective labor share. The downside of the business cycle is called the recessionary gap, but I might call it the anti-inflationary gap.

All graphs use quarterly data. Inflation is CPI less food and energy. (Link to inflation graph at FRED.)

Link to graph #1: Inflationary gaps past and present.

In graph #1, the yellow dots identify the inflationary gaps, when capacity utilization (blue line) is higher than effective labor share (tan line). You can see that inflation (yellow line) increased after the peak of the inflationary gaps in the 1970’s. Inflation also fell in the recessionary gaps (anti-inflationary gaps). But inflation rose just a little after the inflationary gaps in the 1980’s, and barely at all for the last 20 years.

Why did inflation stop occurring with inflationary gaps?

Above I presented an equation for the tendency for inflation to rise or fall. Well… How do we know who has more prowess in the market, consumers or firms? The measurement I use comes from what I call the optimal level of the Super macroeconomic potential GDP. (If you want to read about it, here is the link. The explanation is wonkish.)

Here is the equation used for evaluating who has the greater prowess, consumers or firms…

The equation gives the optimal level of capacity utilization (cu*) at any moment for the economy. The independent variables in the equation are effective labor share (els), real GDP (Y) and a business cycle amplitude constant (a) in terms of real dollars.

Since capacity utilization rises and falls through the business cycle, the optimum point represents the center of the business cycle, where capacity utilization is equal to effective labor share. If effective labor share is on balance above the optimal capacity utilization, capacity utilization will be over optimal. Thus, when labor share is too high for optimality, the implication is that the prowess of labor’s liquidity is greater than the prowess of firms to manage products. And inflation will tend to rise.

On the other side, when effective labor share is below the optimal level of capacity utilization, capacity utilization will be lower than optimal on balance and firms will have the greater prowess to make the inflation tendency negative. In this situation, real GDP rises upon a lower utilization of capital and labor which manifests as high corporate profits. Labor share falls to a level which is not optimal for the economy, but corporate profits will rise. The lower labor share means lower liquidity prowess for consumers, and greater prowess of firms in an atmosphere of high unemployment. As labor and capital become under-utilized, a dead-weight loss to society develops.

Link to graph #2: Optimal level of labor share.

Optimal capacity utilization (brown line) has been rising through the years to currently around 88%. However, labor share has been falling. Effective labor share was above optimal in the 1970’s, which gave consumers the prowess edge in the market. The 1970’s was a time of positive inflation tendency. But ever since the 1980’s, effective labor share has been below the optimal level giving the edge to firms to control and subdue inflation. Effective labor share has fallen to around 74%.

The rising of the optimum level of capacity utilization to such a high level indicates that the US economy has matured. The focus since the 1980’s should have been on distributing more national income to consumers, and letting the consumers save their money for investment. Lessons to learn… Now monetary policy is dead, but that is another issue.

You can see at the end of 1990, that as effective labor share disengages from the optimal line, inflation begins to fall flat for years afterward.

Comparing effective labor share to the optimal level of capacity utilization allows us to identify a period when inflation tended to rise, and the current era when inflation tends to fall. Inflation was more volatile when effective labor share was higher than optimal. Consumers had the power to purchase at higher prices and the dynamic was harder to control. But there are other problems now.

(note: Milton Friedman’s complaints about the power of labor and the minimum wage came at a time when labor had more power than business. But the tables turned during the 1980’s and now his complaints would be inappropriate.)

So far we have looked at two factors that have affected inflation over the years.

1. the inflationary gaps which used to have more effect.
2. the optimal level of effective labor share which shows the shift in prowess from consumers (labor) to firms.

But there is another factor, which adds more insight into the shaping of inflation… The natural rate of interest.

Many economists use the real rate of interest and expected inflation in their models for inflation, as does David Romer. It is easier to determine the real rate than the natural rate. Yet, I have a way to determine the natural rate of interest from the effective demand monetary equation. (Here is a link for an explanation. Again wonkish.)

The equation for the natural rate of interest is…

Natural rate of interest (center of business cycle) = z * ((ea-un)2+e2) – (1-z) * (ea-un+e) – it

z = z coefficient to position monetary framework (z shifts as the effective labor share anchor shifts.)
ea = Effective labor share anchor (currently 74%)
un = natural rate of unemployment (assumed to be 5% in equation, 7% since 2009)
e = effective labor share
it = inflation target in Fed monetary policy (assumed to be 2% in equation)

The natural rate of interest is very helpful to have, if you can get it. The natural rate of interest that I calculate is for the center of the business cycle. To be clear, it is for the point in the business cycle between the recessionary gap and the inflationary gap. I could also calculate the natural rate of interest at the LRAS curve where real GDP hits the effective demand limit, but I want to focus on the inflationary and recessionary gaps in this post.

If the economy was in balance at the point between the recessionary and inflationary gaps, then the Fed funds rate would theoretically equal the natural rate of interest to keep the economy in balance. During a recessionary gap, the Fed funds rate would theoretically be below the natural rate of interest in order to support the economy to recover from a recession. During an inflationary gap, the Fed funds rate would theoretically be above the natural rate to control over-heating of the economy and to control inflation.

So what do we see when we compare the Fed rate to the natural rate of interest?

Link to graph #3: The natural rate of interest and the Fed rate.

The Fed funds rate is the green line. The natural rate of interest (center of business cycle) is the brown line. Back in the 1970’s and 1980’s, the Fed rate was always above the natural rate of interest, whether in an inflationary or recessionary gap. Such was the fervor to control inflation. During the 1990’s, the Fed rate stayed close to the natural rate, even as it rose to battle the double inflationary gaps in 1995 and 1997, even when there wasn’t any inflation to speak of. Since the 2001 recession, the Fed rate is spending much more time below the natural rate, so is the inflation rate too.

You might notice that the natural rate of interest (brown line) mirrors the effective labor share rate (light tan line). The mechanism is as labor share rises, there is more liquidity for consumption, which gives consumers a greater prowess to raise inflation. The natural rate will rise to balance that effect and show that the Fed rate should rise a bit more to control that relatively positive inflation tendency.

I want to put all the lines into one graph and make a few more comments…

Link to graph #4: All variables in one graph.

• It is implied that if labor share was now at the same level it was at in the 1970’s, there would be less positive inflation tendency due to a higher level of optimal level of capacity utilization.
• Inflation moved below the natural rate of interest near the end of 1997, the same time that capacity utilization fell for good below its optimal level.
• In 2006 and 2007, the Fed rate was over the natural rate during the inflationary gap, which would have been normal in years past. However, inflation had hardly moved and the Fed looks to have over-reacted. The Fed could have kept the Fed rate lower and allowed a bit more inflation. Some criticize the Fed for being too tight. It depends on how you look at it.
• Currently we are in an inflationary gap, and inflation has been ticking down. Labor share fell first, but now labor share will stay steady. Inflation will most likely stay steady and rise a bit from here. There is not much danger of deflation.
• Just as the Fed rate stayed over the natural interest rate back in the 1970’s and 1980’s, the Fed rate will now want to stay below the natural rate due to a strong negative inflation tendency. The Fed rate will now be stuck on the zero lower bound, as long as the effective labor share stays so far below optimum. The inflation tendency will stay negative for quite some time it looks like.

And what will happen to the natural interest rate that seems to be falling? It will stabilize around 2%. The variables in the equation for the natural interest rate are stabilizing. However, if labor share starts to rise again, the natural interest rate will rise too. If labor share falls even more, the natural rate would push lower, which wouldn’t be advisable. A lower natural rate would represent a really sick economy.