The Fed messed up
This post will build upon my previous post with the Cobra equation. In that post, I gave a model showing that the Fed is completely behind the curve of the business cycle. The Fed should not be raising rates at this point in the business cycle.
When to Normalize in Theory
In the model, aggregate profit rates have a somewhat circular movement through a business cycle. I say somewhat because in other business cycles, the circular movement looks more like a bouncing ball off of the effective demand limit.
In the green portion of the cycle, aggregate profit rates are increasing. There is broad momentum to expand utilization of labor and capital. It is the best time for interest rates to get on a path to normalization. The economy can withstand the good medicine of normalizing interest rates because of the momentum of increasing profit rates.
If US interest rates are too low or too high in the green area, global imbalances will grow to some extent. In the present business cycle, inflation and the labor market looked weak, interest rates were kept low. Even though the economy seems weak and fragile in the green area, the underlying profit momentum drives economic developments and possibly imbalances. Normalizing interest rates are meant to moderate those imbalances.
So the Fed decided not to normalize interest rates because the economy seemed weak and partly because economists like Paul Krugman said the Fed needed to wait for inflation. But global debt accumulated, even emerging market debt, because interest rates were not normalizing in the US.
The accumulated debt is a problem that hinders growth. Apart from there just being more debt, much of the debt in emerging markets is in US dollars. So if interest rates are normalizing in the US, there is a control over too much US dollar debt developing in emerging markets. That is a good thing, because now we see greater problems as the cycle begins to tighten with monetary policy and peaked profit rates.
Also in hindsight, the increased use of US dollars in emerging markets is a problem now that commodity prices are falling. As well, the devaluation of the Chinese Renmibi may have occurred earlier in a more balanced way, if the US had been normalizing interest rates earlier.
So what has the Fed done?
This graph seeks to show that the Fed should have been normalizing interest rates in the green area when there was the momentum of increasing aggregate profits rates. The “global” economy would have had better discipline, better balance in order to not create cyclical debt imbalances in US dollars. (Cyclical means that at a certain point in the business cycle, the imbalance becomes a problem.)
Moreover, the efficiency of the US economy would have been greater. Higher interest rates imply more productive companies and consequently better net social benefits, as long as the interest rates are normalizing with the profit rate cycle and with a correct estimate of the real natural rate.
The generally accepted normalized rate for the Fed rate is between 3% and 4%. We are far from there.
The Fed should have been normalizing rates in the green area, and certainly not in the red circle… as they have done. They are completely behind the curve.
With aggregate profit rates peaked for over a year now, it is clear that the business cycle has peaked. So from what I see, the Fed has really messed up, even Paul Krugman. They seem to think that the economy is still within or arriving at the green area of the business cycle.
Now is absolutely the wrong point in the profit rate cycle to be normalizing rates. In a normal cycle, this would be the time that interest rates peak or even fall, but not rise. The Fed can tip the economy into recession.
As I have said before, the Fed will go through some deep soul-searching… as things will not turn out well for them.
EL – What is the most recent data you use in your model? What month/quarter are you currently using?
BK
December 2015. The grqph has monthly data points.
EL – Where do you get the profit rates?
BK,
You can check out figures 23 to 25 in this link which was published yesterday…
http://www.yardeni.com/pub/ppphb.pdf
I would suggest that Krugman like Clinton knows to advance in a crony capitalist environment one must support the present system.
Or is Krugman as suggested by Tyler Durden “Essentially a sadomonetarist is a job-hating heretic who doesn’t believe that printing mountains of fiat currency solves economic problems and who is motivated by an overwhelming desire to perpetuate global inequality by enriching creditors at the expense of impoverished debtors.”
More…… http://www.zerohedge.com/news/2015-03-16/worlds-oldest-central-bank-asks-paul-krugman-shut
EL – Thanks for the link. I took a look, the profit numbers from Yardin are from Q3 2015. Meaning this is data from July-September of 2015.
Is that the data you use?
I most often see Tyler Durden at Globalresearch.com not much any where else and you know why. As for the NYT endorsement of “more the same b.s.”.for the Clintons who I hope do not again fool the American people.. For more detail go see Pam Martens at today’s Wallstreetonparade.com . The Clinton’s will not restore the Glass-Steagall as the big 6 banks families have already paid them not to do so…Lets make America better not broker…Today its not just about right or left but more the up vs down in the economic wealth inequality. Korrupt Krony Kapitalism is eating our democratic values as the 1% oligarchs will not self identify their dirty political money influences and abuses…
More from Pam Marten on Clinton’s war on the poor, and crony capitalism……http://wallstreetonparade.com/
EL – yes, Yardini published his report yesterday…..
….And the slides you point to are data on profits from Q3 2015. So the info you are drawing conclusions from is 4-7 months old.
The Fed’s job is to make choices based on what they think will happen tomorrow, not what happened six months ago. There are many ‘real time’ data sets that are taken into consideration.
The Fed may well be making a mistake, but if they are, it will not be a mistake based on stale profit data.
BK,
I have my own calculations of aggregate profit. You will hear in the news that aggregate profits have been falling. Check out Boom Bust.
Yet, you will see as time goes on that the recovery ended. My models point to effective demand as the limit that determined the end of the recovery, because the recovery ended when the economy hit my limits.
EL You have your own calculations? Only you have the secret sauce?
Yes profits are down. They are down much further today then they were in September. Energy investments have fallen $400B since then. The question you have to ask and answer is not what happened in the past, but what will happen in the future.
But for the record, what date was it that, “the economy hit my limits”?
BK
You seem like a prosecutor expecting to find guilt. The only thing you will eventually need to do is understand my models. They are working and you do not know why. So you are suspicious.
But the date? … 3rd quarter 2014…
https://research.stlouisfed.org/fred2/graph/?g=3jiS
It is when the plot in the FRED graph here bottomed out.
Edward,
If I understand correctly, you have a model that predicts profits based on unemployment, capacity utilization, and labor share. I don’t think you have shown us the extent to which your cobra equation matches the data to which Bruce K was referring.
Also, as I have tried to express before, I don’t understand how I should expect your model to deal with the possibility of an economy that grows with population without having significant cycles. The numbers for demand and for profit will increase even as normalized employment stays constant.
Arne,
The cobra equation is another way to model an effective demand limit. It models a path for the economy to take through the business cycle and against the effective demand limit.
As we have seen over the past year, the path of unemployment and capacity util followed the max limit of the cobra equation quite perfectly.
And to your question on population… ratios can stay constant even as total numbers grow. The key to effective demand is in the ratios. You might for example that the natural rate of unemployment would change with population growth or decline, but population is not the determining factor.