Inflation is not a reason to normalize nominal rates… Lower potential output is

There is a concern that many economists want the Federal Reserve to tighten monetary policy because the inflation monster is lurking out there. Maybe tighten is not the best word to use. “Normalize” monetary policy is a better term. Well anyway, the inflation monster is not lurking while labor share rises so slowly.

Then, is there a reason to normalize monetary policy? Yes… Lower potential output.

We read in some blogs today that inequality lowers growth potential. But now the logical conclusion is that potential output really must be lower than the CBO projects. In which case, we are much closer to the end of the business cycle than many think. And the Federal Reserve would not like to have a zero lower bound nominal interest rate as the business cycle tops out. They would prefer some traction if the economy started to sputter.

Can you imagine how embarrassing it would be for the Federal Reserve to have an effective zero lower bound nominal rate if a recession started? There would be incredible soul-searching.

Well, the Fed has dug themselves into a slippery mud hole with little traction to get out. The end of the business cycle is closer than they think if one sees lower growth potential due to highly increased inequality AFTER the crisis. And they will not be able to raise nominal rates fast enough, especially if they plan to raise nominal rates by 25 basis points per quarter. So if the business cycle tops out mid-2015, they might have a 0.50% effective Fed rate. This rate is effectively a zero lower bound rate.

But really, it is too late for monetary policy to normalize now. There is not enough time. The planned rise in nominal rates is too slow, and raising them faster would be too much for the markets to handle.