The Fed rate… What is going on with the Fed rate? The Fed say they would like to raise it in December. Others say they should wait.
Using an Effective Demand Version of the IS-LM curve
In a normal IS-LM model, the interest rate is on the y-axis and output on the x-axis. The following model will keep the interest rate on the y-axis, but put a measure for the utilization of labor and capital for output on the x-axis. The measure is TFUR which multiplies the capacity utilization rate by (1 – unemployment rate). This version of the IS-LM model makes it easier to compare business cycles.
The model shows that the Fed rate would normally rise as the business cycle expands and more labor and capital are utilized. Eventually the Fed rate will normalize at an interest rate equal to the inflation target + the natural real rate. According to this model, the normalization of the Fed rate will take place at the effective demand limit.
In the above model, the vertical dashed green line is the effective demand limit based upon an effective labor share of 80%. The effective demand limit is the projected labor share at full employment. (Labor share is calculated by labor share index: non-farm business * 0.762) The effective demand limit is the limit that the TFUR utilization of labor and capital will reach at full employment.
The Model before the Crisis
This graph adds actual data from 1stQ 2002 to the present.
As the expansion ensued after the 2001 recession, labor share was around 80%. The curving red arrow shows how the Fed rate was moving along a path associated with an 80% effective labor share, 2% inflation target and an estimated natural real rate of 2.3%.
The Fed rate was heading toward normalization at 4.3%. But then something unusual happened during the expansion. Labor share fell quickly to 77.3%. Effective labor share had never fallen to that level before. The up-sloping path shifted left.
All of a sudden, the Fed rate was too low according to the prescribed path. Was the Fed surprised by the changes it began to see in the economy? I think so… The Fed rate appeared to rise faster toward the new green dot of normalization but really utilization of labor capital were slowing down. Imbalances in core inflation and bubbles were developing. Ultimately, the Fed rate rose above the normalization rate of 4.3% to control inflation pressures and bubble imbalances.
The economy went into recession for many reasons, but one reason is that the Fed rate probably went a bit too high. The Fed rate should have stayed near 4% during 2007 in my opinion.
After the Crisis
The economy is confusing after the crisis. There are large differences in estimating potential output. There are large differences in estimating the natural real rate. So this graph shows two views of the economy.
The blue line shows a more optimistic view than the yellow line. The blue line is based on a higher utilization of labor and capital at full employment (82%), yellow (80%). The blue line is also based on a higher natural real rate (1.5%), yellow (-1.0%).
The blue line sees normalization eventually at 3.5%, yellow 1.0%. These points are shown by the green dots.
The red dot along the zero lower bound shows us where the economy was in the 3rd quarter. We can see that the Fed rate is lower at the same TFUR than before the crisis. It has actually never been this low at a TFUR of 74% since at least the 1960s.
If one agrees more with the blue line, they see the Fed rate getting ready to liftoff. If one, like Larry Summers and others, agrees more with the yellow line, then they would say that the Fed rate is far from liftoff.
Note: According to the model, as the effective labor share rises, the vertical dashed green line slides right leading to a higher Fed rate at normalization. The current effective labor share is lower now than before the crisis at 75%. So far the utilization of labor and capital is meeting up with resistance at 75% on the x-axi. If the effective demand limit at 75% holds, the Fed rate will have no space to rise and will stay at the ZLB. The Fed would end up being surprised by the unseen limit.
Which line would you agree with? How might you change the line to your own views? Would you change the slope of the line?