Stan Fischer has curve upside-down

Stan Fischer, vice-chairman of the Fed, gave a speech yesterday. (link) He said this…

“As we noted in our statement, we continue to expect that the evolution of the economy will warrant some gradual increases in the federal funds rate over time to achieve and maintain our objectives. That assessment is based on our view that the neutral nominal federal funds rate–that is, the interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel–is currently low by historical standards. With the federal funds rate modestly below the neutral rate, the current stance of monetary policy should be viewed as modestly accommodative, which is appropriate to foster further progress toward our objectives. But since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future, and gradual increases in the federal funds rate will likely be sufficient to get monetary policy to a neutral stance over the next few years.”

I have highlighted the ideas that I will focus on.

Fischer is saying that the current Fed nominal rate is just below the neutral nominal rate. I agree. However, the neutral nominal rate has been falling. It appears he thinks it is rising. Here is a graph explaining what I mean.


The orange line shows the actual Effective Fed rate. The violet line shows my estimate of the neutral nominal rate according to the business profit cycle of effective demand. The graph shows my estimate a bit above the actual Fed rate, but it is trending downward (falling blue arrow).

Fischer also estimates that the neutral rate is a bit above the current Fed rate, so he says that monetary policy is modestly accommodative. However, he believes that the neutral nominal rate is rising (rising red arrow) because he says there is little risk of falling behind the curve.

One of us sees the curve upside-down and I believe it is he. He sees the curve going up, while I see it going down. The business cycle is showing signs of coming to an end. Profits are coming down for over a year. Unemployment is flat-lining. Auto sales have peaked. Year-over-year change in non-farm employment is trending down. There are more signals that the business cycle is decaying into a contraction.

Fischer believes that the Fed rate can rise safely at some point. But from my point of view, any rise in the Fed rate will bump against a falling nominal neutral rate.

The Fed has been behind the curve for years and did not know it, basically because they do not have a grasp of potential GDP. Here is my estimation of the Real output gap against the CBO’s. My estimation is based on comparing an effective labor share number against capacity utilization, which is optimized when the business cycle reaches its peak. Capacity utilization has alreacy been optimized in this business cycle.

output gap

The CBO sees real GDP still about $300 billion below potential. They see the curve still rising. Whereas I see that the output gap has already gone through a normal business cycle peak shown in the rose-highlighted area. I see the output gap already falling toward a contraction. Therefore, I see the curve going down.

The Fed should not raise the Fed rate. Monetary policy will tighten on its own as the business cycle further decays over time.