The Progressive Death of the Fed Funds Rate
I started blogging last March. Since then, one of my most visited posts presented a model to show the progressive death of the Fed rate. Basically, the effective zone of the Fed rate is being pushed lower and lower as effective demand declines due to the decline in labor share.
In the following graph, I plot the Fed funds rate on the y-axis and the TFUR on the x-axis. (TFUR, total factor utilization rate = (capacity utilization * (1 – umemployment rate)).
The blue line is the actual Fed funds rate since 1988 in relation to the TFUR. You can see that the blue line has moved within a corridor. The Fed rate rises as the economy heats up from more labor and capital being utilized.
The vertical red lines represent the effective demand limit that has been shifting left over the years. The blue line has been shifting left too because it does not cross the vertical red line of the effective demand limit.
What does this mean? As the red line of the effective demand limit shifted left, the Fed funds rate was progressively pushed down the corridor into a zone of non-traction… a zone of the liquidity trap. It is the progressive death of the Fed funds rate.
You can see that the blue line rose up against the middle vertical red line before falling into the crisis of 2008. Then you can also see that the blue line has been tracking along the zero lower bound and is now reaching the lower boundary of the effective demand corridor. Yet the forward guidance of the Fed is saying that they will keep the Fed rate below that lower boundary. The Fed rate has never gone beyond that lower boundary. Why? Well, the TFUR does not go past the effective demand limit. The utilization of labor and capital will not go much beyond labor’s share of income.
If labor share keeps dropping, the Fed rate will completely die. If labor share stays where it is, the Fed rate will face low utilization of labor and capital for years. But if labor share can increase significantly, the Fed rate will resuscitate and rise back to a healthy zone.
The mechanism… a low Fed rate is designed to create more demand liquidity in the economy. But labor share has fallen 10% since the early 2000’s. A lower labor share decreases the potential of liquidity to return to the economy to where it was. So the low Fed rate is fighting a losing battle in trying to get the economy back to where it was. The relative potential of demand liquidity for consumption is just not strong enough anymore. And pushing a low rate to overcome that limit will create some hefty imbalances.
Great chart. Did you try pushing the beginning year further back?
The Fed has been reducing the Fed Funds Rate since about 1981.
See this chart: http://research.stlouisfed.org/fred2/series/FEDFUNDS
It could be argued that the initial reductions were to move away from Volcker’s high rates, which were used to end excessive inflation in the economy.
I have been arguing for years that the Fed Fund Rate reductions served to mask the deteriorating economic condition of consumers.
Mainstream economists should have taken note of this and issued dire warnings by the mid 1990s anyway.
You wrote “The mechanism… a low Fed rate is designed to create more demand liquidity in the economy.”
This makes me wonder what they intend to do when we have our next recession?
How did people accept your perception that the Fed rate reductions showed deteriorating conditions for consumers?
You are right… economists should have taken note, but even Krugman was undermining the living wage movement.
Our next recession will widen the eyes of many economists, if not all economists.
There are several major reasons why domestic demand has been weaker after 2000.
1. U.S. firms have more market power, after the quick and massive creative-destruction process, mostly from 2000-02. So, rather than prices falling, profits rose, which reduces demand for those goods. This is particularly true in the Information-Age and Biotech Revolutions, e.g. paying too much for internet services, iPhones and cell phone services, new drugs, etc..
2. More regulations (federal and state), which are regressive, have driven-up the cost of living. So, there’s less to spend on everything else, ceteris paribus.
3. More taxes, fees, fines, fares, tolls, etc., which much are also regressive, including by state and local governments.
4. Higher gasoline prices, from the oil shock and Peak Oil, is a tax on consumption.
5. Imports became increasingly cheaper. So, there was likely some shift from domestic goods to foreign goods.
It should be noted, real wages would be higher with lower prices or a lower cost of living. However, inflation has become increasingly less of a problem, because the U.S. has been like a Black Hole in the global economy, attracting imports and capital, and even the owners of that capital themselves. Moreover, it should be noted, the U.S. has bridged the low income and high consumption gap with mountains of household and federal debt.
“But if labor share can increase significantly, the Fed rate will resuscitate and rise back to a healthy zone.”
It seems unlikely that the labor share will increase significantly; isn’t the probability greater that the trend will continue and labor share will decrease further? It’s not as if the Fed saw the housing bubble and responded appropriately. If labor share stagnates or decreases, what then? What is the result of the “hefty imbalances”?
PeakTrader – all good points, especially about market/monopoly power, unfortunately the trend is not our friend…
It is quite possible that labor share still wants to go lower. If that happens, the US economy will fall another notch downward. That means lower capacity utilization and lower employment.
The result of the hefty imbalances is greater instability and more difficulty returning social balance to the economy. By social balance, I mean economic social benefits. Overall, society will lose and inequality will get even greater.
I am watching the economy as it moves forward into 2014. The run up of real GDP in the last 2 quarters of 2013 was impressive….
Sorry for the delay, I have been out of town.
“How did people accept your perception that the Fed rate reductions showed deteriorating conditions for consumers?”
In general they just ignored the observation.
Apparently they never fully appreciated that this represented more and more stimulus being applied to an economy which was not in a declared recession.