An Effective Demand theory of the Fed Rate through the Business Cycle
In time, we will see a debate start raging as to whether the Fed rate should have started rising earlier instead of at the end of 2015. Some like me say that the Fed rate should have started rising earlier because the market had momentum and the capacity to accept the rate rises. Others say the market had to wait to tighten the labor market more and try to generate some inflation.
A Theory of the Fed Rate Movements based on Effective Demand
A measure of the effective demand limit gives a view of spare capacity in the economy through the business cycle.
The plot shows spare capacity in the economy in terms of labor and capital. The plot in the graph above expands upward during a recession, then contracts downward through a business cycle. When the plot is high, there is more spare capacity that can be utilized and the Fed rate should be lower than its normalized rate.
How could the Fed rate change in relation to this graph?
The Fed rate would fall during a recession as spare capacity rises. Then as spare capacity gets utilized, the Fed rate should start rising again toward its neutral natural rate. In theory, the Fed rate would ideally normalize when the plot reaches near zero.
The Fed rate would change something very roughly like this… (range is 5% normalized Fed rate which falls to around 2% during a recession)
The Fed rate would fall during a recession and when spare capacity is rising. The Fed rate would rise when spare capacity falls to around 5% on graph until it reaches a 5% normalized rate when the blue plot reaches near zero.
How well has the actual Fed rate followed this pattern?
Compare how the brown and red lines move up and down together. The two lines do seem to move together roughly at the same times. So the Fed rate has already followed the pattern. (link to FRED data)
Note… The Fed rate should not have risen before the 2001 recession when the spare capacity was actually rising.
A Graph for a Theory of the Fed Rate through the Biz Cycle
Basically a theory would say that the Fed rate should start rising when the plot is falling between the red lines. Once the plot goes below the red lines, the Fed rate should not rise, but stay steady and be ready to come down to preserve the natural level of full employment. Then the Fed rate should come down when the plot is rising above the lower red line.
According to this simple theoretical model, the Fed rate should have started rising moderately back in 2012 or 2013 (update: assuming a normalized Fed rate of 3% to 4%). And now is not the time for the Fed rate to start rising toward a normalized natural rate since the plot has already bottomed out. A rising Fed rate now will eventually strangle the economy which has very little spare capacity.
I use this theory to say that the Fed should have started raising the Fed rate moderately earlier in the recovery.
Have you seen this ? :
“…Accounting for this kind of capital investment means that the decline in the U.S. labor share starts much earlier than previously thought. According to the paper, the decline starts in 1947, which would mean the labor share was declining throughout the period it was famously stated to be constant.”
“….While the overall trend since 1947 is a decline in the U.S. labor share, the data in the paper does show a leveling-off of the share from 1980 to 2000 and then a decline from 2000 onward. ”
I’m wondering how the revised labor share calculations would effect your effective demand graphs. The pattern since 1980 probably wouldn’t differ by much , but it seems like the changes for the 1947-1980 period might have some impact.
At the very least this is a cautionary tale : The way we choose to define economic terms ( e.g. , Is R&D a business expense or an investment ? ) has a trickle-down effect on how we quantify other parameters.
The labor share data that comes out now is balanced with other data like unit labor costs and inflation. So the labor share that we have now has a good history of evolution. The current data is working with other data. If we were to change labor share, we would end up separating it from other data and making it less useful. So I continue to trust the labor share that is given. It is the best labor share data in the world.
You can still see that labor share has been sliding downward since the 1940’s in official data.
oh… and if you changed the way labor share is measured, you would have to change the way capacity utilization is measured to arrive a translatable effective demand limit.
The “actual Fed rate” line in your graphs illustrates the problem in giving the Fed too much discretion in the rate-setting process. They tend to go from jamming hard on the brakes to flooring the accelerator. The economy gets whiplash.
What the Fed needs is a governor. Ha !
I finally got a chance to take a look at the paper referenced in the equitablegrowth.org article. It turns out that the BEA revised the data in 2013 to account properly for intellectual property capitalization , so you’re right that your calculations are using the best available data , to whatever extent there exists a “best” dataset.
Still , it would be interesting to know how your analysis would be impacted by using the pre-2013 revisions data. If you look at Fig E-1 , panel C , here ……
…. you see that the difference in calculated labor share is dramatically different pre- vs post-revision , using data back to 1929. The pre-revision data shows a flat-to-slightly increasing labor share all the way up to ~2001 , while the post-revision data shows a steady decline throughout , with a sharper downturn ~2001.
That figure thus shows a pretty dramatic – and important , as your work illustrates – change in the official view of factor shares , and it makes we wonder how it could go unrecognized and uncorrected as late as 2013.
This graph from an old ritholtz.com piece shows what the FRED labor share graph looked like in 2011 , i.e. , pre-revision :
I will continue to use the labor share data that is balanced with other data. Otherwise it is like comparing apples and oranges.
Ritholtz hits hard in that article saying that the capitalism we have now is distorted with parasites killing the host. He is a good guy.