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…
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.
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…
Where does that formula come from?
This is a pretty good model of the long term interest rate:
log r = 0.55 log(NGDP/MZM) – 4.27
Also, the same functional form can be used to describe the long term and short term interest rate simultaneously:
Interesting and creative work you are doing…
My formula came through concentration. I was concentrating on the patterns with my eyes closed. Then a basic form of the formula appeared in the back of my mind. I have cleaned up the formula since then. So I really do not know where that formula came from, only the back of my mind.
But the formula only uses regular data. I mean, the formula does not need statistically calculated coefficients to mold the formula to fit data. Labor share index, capacity utilization, unemployment, natural real rate, inflation and an inflation target is all that you need to run the formula. In essence, the formula could be applied to any economy without needing to identify statistical variation. It is kind of like a law of economics in that way.
So the party will end when? Within the next year by next summer?
“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.”
So we won’t get stagflation like the 70s. Instead of demand-pull inflation with rising prices, you’ll get the rich with more money and what? Rising asset prices? Janet Yellen at the Fed warning that certain classes like the junk bond are overpriced? Will we see the euthanasia of the rentier as capital becomes cheaper?
Asset prices don-t look to be rising much going forward. There is a general pull-back from investing. Capital is starting to protect its assets and not pushing prices.
When I look at past patterns, a recession has to form over time, like 1 to 3 years. We will see signs developing that point to a recession forming. I do not see them forming yet in the US. But the past patterns suggest that they will be appearing within the next 6 months.
My sense is that the present economy will not be able to float on the edge of recession for very long like before past recessions. Markets are too sensitive to monetary policy, and there is little momentum from productivity and inflation.
So my sense is that the recession will come on faster than before once the effective demand limit signs really start to show. I get a feeling we are going to watch a very dramatic situation unfold when it does.
I don’t see it. If more money is going into the hands of the rich and it is, you get downturns like 87 and 2001.
What don’t you see? or better, What do you see going forward?
Asset appreciation does not require any real work by anyone. Unlike the housing boom I do not see a strong feedback to the rest of the economy where real work is needed.
So, even if there is a recession in the currently inflated part of the economy, will there be much effect on most workers?
Your question is an important one… Labor’s lot lies squarely on raising labor’s share. This will give them more economic leverage in the economy to consume and control resources.
There still seems pressure to hold down wages as inflation expectations are so suppressed. Labor will simply have to fight for what they deserve to balance the economy in a healthy way.
What do you think?
It seems likely that this sort of stagnation is no bother to the 0.1% but rather a benefit.
Ownership of resources need not grant big returns, so long as it grants control of the whole economy. Low growth and stagnant wages are no problem, because the whole ant farm is owned and controlled. It is even possible that some of the 0.1% recognize that growth as such is at the end of its run (limited by the size of the planet and ecosystem, among other things,) and accept control and stagnation is their own happy solution to the problem of limits.
Noni… Your words ring truth.
That is why labor must fight and fight hard… as labor gets pushed into the mud and laughed at, they will get angrier…
What I was thinking was like this:
If labor’s share of the economy is 12T and capital’s is 3T and the it goes to 12T and 4T, then labor is stagnant, but has not lost anything for the fact that 12/16 is smaller than 12/15. When it goes back to 12 and 15 again, you have a recession, but labor is not damaged.
In 2008, when assets crashed, it did impact labor, but I wonder if the asset bubble you are seeing now will pop without dragging us down too much.
Your graph is *very* interesting. Also this:
“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.”
(But I would suggest again that what you are measuring is potential demand, not effective demand. Thus there is symmetry in the tussle between potential supply and potential demand.)
Regarding the 1970s you write:
“the Fed rate was loose for years. An imbalance resulted from the loose Fed rate. The imbalance that developed was inflation.”
I agree there was monetary imbalance. But inflation was not the imbalance. Inflation is the economy’s way of correcting an imbalance.
The graph is interesting but it would be more interesting if you added a plot for unemployment.
The Fed may also be considering unemployment when they adjust the rate.
If you are interested, monthly unemployment data is available here:
Click “More Formatting Options”
Then change “From” year to 1968
Then change other options as needed and click “Retrieve Data”.
Click link at top of table to download the table in xlsx format.
Very good read at David Stockman’s blog:
It is a very good discussion of Japan’s economic history since 1985.
His fix completely ignores the primary problem of the Japanese export based economy:
“This condition of credit saturation means that nominal GDP growth is stuck in the low single digits, and could be liberated from that plight only by a burst of supply side growth and entrepreneurial productivity that has no chance of emerging in the statist policy and political environs of Japan Inc.”
Who does he imagine will buy the result of that Japanese productivity? Does anyone believe that Japan has been able to compete with the rest of southeast Asia based on final sales price?
He ends on the problem with the Japanese government debt. I don’t see how they pay this debt and if the central bank raises interest rates he says the interest would consume all their taxes.
This is a warning for those who think that governments can run up debt forever.
Japan will have to lower its standard of living, so as to live on their reduced exporting income. The sooner the better.
The lesson for us is that either we address our fundamental problem which is trade imbalances, or we will have to reduce our standard of living too. Hint, we can’t force other countries to buy more of our exports.
The punchbowl spiked increase in the monetary supply HAS created a boost in inflation. But instead of increasing the price of the constituents of the CPI the price of financial assets has increased. This is of course because the money has been going to those who buy financial assets and not consumer products.
The term “effective” implies a limit. So it is better than “potential”. But the terms are very close.
Potential output has been surpassed many times, but not effective demand. Effective implies the top limit.