Asset prices and Krugman’s low interest rates
Paul Krugman is making a case that asset prices are not high once you realize that interest rates are not artificially low. So why are interest rates not artificially low? He states…
“Once you accept the possibility that rates belong where they are, or even a bit lower, to correspond to the Wicksellian natural rate, you also conclude that asset prices might make sense; and once you concede that asset prices might make sense, you lose the supposed evidence that rates are all wrong.”
His logic depends on there being a large output gap. Thus a very low interest rate is required for the economy to get back to potential output. However, I would make a case that the output gap is much smaller than he says due to effective demand being at historically an all-time low since WWII. Does he talk about effective demand? No. Does he even know how to determine effective demand? Who knows?
The time has not quite come for people to see the effects of the effective demand limit. They are showing themselves in bits and pieces, and people are progressively getting concerned.
Basically, everyone has drawn in the sand where they think potential output is… where the natural level of output is. Now we wait for time to show who came the closest. Because there is no changing the course that we are on. Interest rates will stay low, but potential output has its own destiny.
If effective demand were about to hit the wall(within the next year) then we would be facing a supply constrained economic situation correct?
Then wouldn’t the loose monetary policy of the fed be heavily inflationary?
Yet core PCE measure is still below 2%
Also Edward, what do you expect to happen once we hit effective demand?
Will we.enter a new recession?
Or will the economy just continue to grow at a.slow pace?
Yes, you can envision a supply-constrained economy at the effective demand limit. There would normally be inflationary tendencies. Normally there is wage growth greater than output growth. The stimulative monetary policy of the Fed as the economy expands leads into wage growth instead of output growth at the effective demand limit.
But what do we see now? Wage growth is still muted because of higher than normal unemployment, increase in part-time jobs, weaker wage bargaining, global competition and firms trying to hold down unit labor costs.
In my opinion, the inflationary mini-surge that we see is due to expectations of higher nominal interest rates next year. Some firms are building in some price rises to hedge against that increase in nominal rates. And also the drop in output in the 1st quarter made some firms to raise prices to make up for the drop in output. Inventories came down as output came down. But the price rises are limited due to the constraints on wage growth going forward.
Yet, is wage growth going to stay low through the next year? There will be pressure to raise wages. Along with the view that the Fed will tighten next year, this will create an environment for firms to continually set higher prices to keep pace with wage growth and expected higher nominal rates, which increase the cost of production.
To your second question, when the economy hits the effective demand limit, a recession depends on the ability of the economy to hold production in the face of monetary policy, increasing input costs and increasing consumer demand. The main idea is that profit rates become a zero sum game. if one company gets better profits, this means another company in the aggregate must be losing profit rates. Up until the effective demand limit, the great majority of firms see profit rates rising. Then at the effective demand limit, profit rates stop rising in the aggregate.
There comes a point when firms start to reach for more profit rates. They do this by hiring more and lowering capacity utilization. When some firms find it hard to get good profit rates, the stock market will react and there will be pressures to compete. Some firms will start to lose in the competition.
If you say that at the effective demand limit we will hit a.supply constraint
Two things Come to mind as reasons I question your earlier assertions.
First your argument that increasing productive capacity would not raise the effective demand limit, since increasing productive capacities would prevent the supply constraints.
Second your claim that we are near that limit now, our current capacity utilization of 79.1% is still well below the expected 82-85% where price inflation is expected to accelerate. Meaning we should still have some headroom for growth.