Effective Demand’s sobering effect on the Fed’s Punchbowl

Under normal economic conditions, the Fed funds rate would be higher. Yet, the Fed funds rate has been effectively at the zero lower bound for years. Why? Well, the answer is simple… The Fed has lost track of how to measure potential GDP and true slack. The problem is that the Fed has no awareness of an effective demand limit upon potential GDP.

The Effective Demand model for the Fed Funds Rate

To show that the Fed rate would be higher, I use the rule from my effective demand research for monetary policy. Let’s remember that a rule should be balanced by discretionary policy within limits. Ok, I give the effective demand equation to determine the Fed rate.

Effective Demand Fed Rate Rule = z*(TFUR2 + LSA2) – (1 – z)*(TFUR + LSA) + inflation target + 1.5*(current inflation – inflation target)

z = (2*LSA + NR)/(2*(LSA2 + LSA))

TFUR = Total Factor Utilization Rate, (capacity utilization * (1 – unemployment rate))
LSA = Labor Share Anchor which stays fairly stable throughout a business cycle.
NR = Natural real rate of interest (assumed to be 3% until the 2001 recession, 2.5% up to the end of 2007, then 1.8% thereafter.)
Inflation target = (assumed to be 3.0% up to 1980, and 2.0% thereafter.)
1.5 coefficient = To give the Fed rate leverage when inflation gets off target. Fed rate would change 1.5x more than inflation is off target.

What does this equation look like over time? Here is a graph comparing the Effective Demand Rule to the Effective Fed funds rate since 1968…

 update ED monetary rule cb

When the actual Fed rate (blue) is above the ED rule (orange), I would say that monetary policy is too tight. Likewise when the actual Fed rate is below the ED rule, I would say that monetary policy is too loose.

In general, monetary policy was too loose through the 1970’s… too tight through the 1980’s… too loose in the early 1990’s… too tight around the turn of the century… a bit too loose after the 2001 recession… and pretty spot on right before the crisis. Currently, the Fed rate is very very loose.

The ED rule recently jumped up because inflation, which was trending around 1.6%, rose to 1.9% in the 2nd quarter of 2014 and the rise in the TFUR accelerated with the recent drop in unemployment.

Measuring Slack

The equation for the Effective Demand Monetary Rule measures slack up to the labor share anchor, which represents the Effective Demand Limit. The TFUR is measured against the labor share anchor. Basically, the TFUR rises in a business cycle, while the LSA stays stable.

Since the crisis, the labor share anchor has made a severe shift downward. The labor share anchor had been fairly constant for decades before the crisis. The drop in the LSA caused the effective demand limit to drop, which then leads to a lower potential GDP through constrained demand.

The Fed has not seen this because they do not have a measure of effective demand. The Taylor rule has no awareness of effective demand either. So the Fed is still trying to calculate potential GDP as  a supply potential, instead of as a supply/demand constraint potential.

Is there a Problem in being too Loose?

The Fed rate is very loose now if one views it from the perspective of effective demand. Yet, is that a problem?

Well, let’s go back to the 1970’s where the Fed rate was loose for years. An imbalance resulted from the loose Fed rate. The imbalance that developed was inflation. Eventually Volcker came in and had to balance the imbalance with tighter monetary policy.

What is the imbalance developing now? Massively increasing inequality. The economy is top heavy into the wealth of capital assets. The consumer has been weakened. We do not see inflation because the consumer is truly weak to drive prices. The imbalance is on the other side of the coin… too much money in the hands of the rich.

Could future tightening of monetary policy reverse inequality like it reversed run-away inflation? Tighter monetary policy would help to keep the rich from being able to increase their liquidity, but inequality has much deeper roots in the ideological institutions that manage the economy.

Still, the Fed is behind the curve because they do not see the effective demand limit, which is about to take away the alcohol content in their punchbowl. The party will end sooner then the Fed thinks. There will be a sobering effect as the hard reality of effective demand appears out of nowhere…