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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.

update UT index

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)

theory fr ut

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?

theory fr ut2

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

theory fr ut3

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.

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Back to back quarters of Corp. profit declines… What could it mean?

I saw this tweet today…

Profits peak when the economy reaches its effective demand limit. A recession eventually follows.

How much can the psychology embedded in the tweet move market expectations?

I feel the economy is close to recession (link) but the data do not say that it has started. The business cycle could still bounce off this moment and keep going a while longer. I am waiting for more data from 4thQ 2015. But we need to keep an eye on the Animal Spirits of psychology.

It is another data dependent moment with Animal Spirits in these interesting times.

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Reflections on Tim Duy’s Projections for 2016

Tim Duy gave his projections for 2016. I will go through his 10 points with my reflections from the effective demand point of view.

1. He says that there will be no recession and the economy will stabilize by the end of the year. Yet, I see a higher probability of recession than he does. The economy is already weak from peaked profit rates and vulnerable from already having hit the effective demand limit. China is showing weakness and has also been vulnerable to the effective demand limit of the US. It is possible that the economy could stabilize by the end of the year if labor share continues to rise carefully and not too fast to spook business. The US consumer could come to the rescue and keep the business cycle alive. But then inflation would tend to trend upward and the Fed might be a little too confident to raise rates which could trigger weaknesses in business health.

2. He says that economic growth will soften to around 2%. That is a reasonable position.

3. He says that job growth will decelerate. I agree. He points to 2014 for where job growth peaked. That is when the economy reached the effective demand limit. After the economy hits the effective demand limit, employment must be matched by constraints in capacity utilization. Yet, there reaches a point where unemployment will stop falling. 2016 is the year that I foresee that unemployment stops falling and begins to level out.

4. He says that wage growth will accelerate. I agree. The economy is at its natural output level (potential output). The labor market will tighten and create pressures to raise labor share. We already see this happening.

5. He says that inflation will accelerate. I agree. He thinks this view is a bit wildly optimistic. However, even as we see weakness in the price of oil and gas, core inflation will tend to rise due to a rising labor share of national income. As output slows, prices will tend to push up. So I do not see inflation falling this year. And also, with China having problems, there is a hope that labor share will rise in the US. I share this view with Noah Smith. So problems in China could help resuscitate inflation in the US. But even so, cascading economic weakness globally would weigh down inflation.

6. He says that oil will end the year higher than it began. This is a complicated call. He points to production slowing. Yet, demand is also looking weaker from China who is playing to keep the price of oil at a floor of $38 per barrel. China is losing their strength to control the price of oil. Also, if there is a recession, then the price of oil would fall. My view is that the price of oil will stay between $30 and $47 barring a recession and grand geopolitical conflicts. The Saudis are forcing the price based on their own personal psychological desires. Will they change their whims? What would make them change? By keeping the price of oil low, the Saudis are trying to force North American producers out of business. This is a problem for the US because much of that investment in productive capacity could turn into non-performing loans. This will drive down the markets and potential output once again. But there is an election coming up, and meetings can take place behind close doors to affect the price of oil. It would be like the rumors of meetings with Iran to help Reagan become president during the hostage crisis at the end of Carter’s term. There are so many psychological and political factors around the price of oil that it is tricky to forecast it until the end of the year.

7. He says that stocks will be up, yield curve flattens and US dollar flat to declining. He says that equity gains would be modest. I do not see stocks going up. A year ago I said that the Dow would orbit around 17,300 and it has done just that over the past year. I have also said that the Dow would not go up much above 17,500 and that it would eventually drop from this 17,300 to 17,500 level into a recession. There is no sign of a strong asset bubble to inflate the market above this level after reaching the effective demand limit in 2014. Aggregate profit rates have already peaked when the economy reached the effective demand limit in 2014. The yield curve will flatten too. This makes the economy more vulnerable to a recession. And I agree with him that the US dollar will not rise much from this point. The US economy is not going to look that strong as we move through 2016, but greater problems elsewhere would support the US dollar.

8. He says that single-family housing will get strong. I am not so much in agreement. The job market and wage gains will not be so great as to have single-family housing take off. I expect it to keep trending upward but with only a small acceleration.

9. He says that the Fed will continue to raise rates slowly. I agree. The Fed is in a mindset that the economy is tightening up with slack still available to utilize. From my point of view, slack has already been used up as the economy has already reached the effective demand limit. The Fed can only raise rates very slowly when up against the effective demand limit of peaked profit rates. Still, I see that the Fed will have to think very hard about maintaining a pace to raise rates. The economy is more vulnerable than the Fed appears to think. But they want to get on a path to careful normalization. 2016 should be the year that the Fed realizes that they cannot get back to normalization. Then the debate will rage as to whether they should have raised rates more slowly starting a couple of years ago.

10. He says that productivity is a wild card. I will give the view from my effective demand research. If productivity starts to rise with the economy against the effective demand limit, history since the 1960’s shows that a recession will form. The recession will then release productivity from its effective demand constraint. So wishing for a surge in productivity would contradict a forecast of no recession. Yet, thinking along those lines with Tim Duy, it is possible and somewhat likely to see a rise in productivity. This would be a sign to me that a recession is forming.

May there be peace in your lives, family and communities this year…

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Inventories to Sales Ratio Rising

By way of JimH in the comments section, the ratio of inventories to sales has been rising through 2015.

invent to sales

(link to graph)

Through the 1990’s and into the 2000’s, inventories were dropping with such things as advances in supply chain management and point of sale inventory control. However since the crisis, that trend is reversing. Businesses are keeping more inventory. And especially in 2015, the ratio increased quite a bit.

  • So why is the trend reversing?
  • Is China dumping products?
  • Are oil reserves rising as oil producers pump more and more to maintain cash flow?
  • Are businesses becoming less efficient?
  • Is the economy making businesses less efficient?
  • What effect might this increase have on inflation and employment?
  • To what extent might this new trend be a concern?

Please leave your opinion in the comments section below.

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Checking in on Consumption for Capital and Labor

Periodically I present updated information about consumption from capital and labor income. Using the NIPA accounts and labor share, I can separate consumption by capital and labor.

Total consumption is trending steadily upward.

update total consumption

Even with consumption trending steadily, in 2013 consumption by capital income began to move sideways, while consumption by labor income began to rise. It may be that labor-income consumption has returned to its pre-1999 trend. (In the graph below the amount of consumption is an estimate. The purpose of the graph is to show how the consumption is trending overtime. The actual amount may be above or below what is shown.)

Capital-income consumption is at a historically high level but leveled since 2013.

update cap and labor real consump

National income has been shared with labor in the last couple of years to the extent that labor has been able to use less of their income for consumption than just after the crisis.

update cap and labor consump rate a

I watch to see if capital consumption is declining, which is one signal of an approaching recession. No decline yet as of 3rd Q 2015… Capital income was still enjoying their tremendous bounty since the crisis.

To support the graphs above, consumption per employee began rising in 2013… and has been recently coming down. So rises in labor income are going less than 1-for-1 into consumption. (link)

update cons per employ

The returns to business for raising labor income may be diminishing.

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Cobra’s Unemployment slithers as Capacity Utilization drops

Capacity utilization dropped in November. The drop makes me reflect upon when I first began formulating the equations for effective demand in 2012-13. I made predictions to test the equations. Each prediction guided me to understand effective demand. One early prediction was that the natural rate of unemployment was around 7%.

2013 nat unemploy

This graph comes from a post in May, 2013. The linear trend line for the red dots was heading toward a y-intercept of 7.25, where UT goes to 0%. (UT at 0% represents 0% spare capacity or full-employment of labor and capital.)

The problem was using a linear trend line for only a portion of the data points. The trend line should have been a polynomial using both the red and yellow dots. It would have given a y-intercept of around 6%.

The latest version of the graph looks like this…

update nat unemp poly

Currently the y-intercept is trending to 4.9%. The other trend line shows a natural unemployment rate of 5.1% for data before 2009.

But the unemployment rate ended up falling well below the “better” natural rate of 6%. How did I explain that?

The Cobra equation.

I found the Cobra equation back in October, 2013, to show how unemployment and capacity utilization move together along the effective demand limit. The equation gives a path of increasing profits alongside the effective demand limit.

The Cobra equation implied that as unemployment falls at the effective demand limit, capacity utilization will also fall instead of rise… giving more room for unemployment to fall further. Business cycles had followed this equation before… Would this business cycle follow it?

I was not sure at that point how low unemployment would really go. I wrote back in October, 2013…

“I was projecting a lower limit of 7% for unemployment, but that was based on capital utilization rising. Now I have to reconfigure how low unemployment might go.” link

So did capacity utilization and unemployment end up following the Cobra equation? Yes, near the end of 2014, they started following the Cobra’s profit-max limit. Here is the latest graph using monthly data that includes the data for capacity utilization that came out today.

update 3d monthly


Just as the Cobra equation predicted, aggregate capacity utilization dropped so that unemployment could slither further downward along the profit-max limit… and it fell nicely parallel to the limit.

Finding the Cobra equation in 2013 before the economy followed it again in this weird business cycle gives me comfort. The original model of a natural unemployment rate was re-worked to a better model of unemployment along the effective demand limit.

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Markets Slipping…

As I watch the Dow slip below my attractor level of 17,300, the Fed rate is expected to lift off this week, oil is near $36/barrel and Christmas is close. Usually the markets try to hold their value through the holidays, so this slipping in the stock markets is something to watch.

When the Dow goes below 17,300, I wonder if the markets will stay below that level and eventually just keep going down. The markets have hit their top. The aggregate profit-equilibrium level was reached about a year ago. Profits are down amongst oil producers but up elsewhere in the economy. However, if oil prices were higher, we would probably have seen the opposite… profits up amongst oil producers and lower elsewhere.

A recession will happen when a certain number of businesses start to contract. They then further cause other businesses to contract. What can cause that? An overly strong rise in the Fed rate or even excruciatingly low oil prices leaving North American oil producers without extended credit.

Some say the economy can overcome these moments and that the future is bright. Others, like me, say a recession will happen before the Fed rate reaches its 3% natural level for a full-employment economy with stable inflation. It would be nice to reach that level, but when the business cycle has already passed its aggregate profit-equilibrium point, contractions in business are harder to overcome.

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Japan should raise wages

I direct you to an article by Adam Posen and Olivier Blanchard called, Japan’s solution is to raise wages by 10%. (Link)

The only way that Japan is going to get its needed inflation is to firmly raise the wages of labor. Many of us knew Abenomics was not going to work unless wages rose. And they never did enough. Now there must be concerted action by labor, business and the government to raise them.

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Estimating Effective Demand toward a Recession

The new update to 3Q labor share came out today. The last two quarters were revised firmly upward. Investors may be concerned about profits after these revisions.

I have my own estimation of an effective demand limit upon a business cycle which is based on labor share, capacity utilization and unemployment. Labor share represents effective demand. The graph basically measures spare capacity as the difference between labor share and a composite of utilizing capital and labor. The more labor share, the more spare capacity can be utilized.

update UT index

(link to graph and equation)

The current business cycle has followed perfectly so far my projection that the plot line would be limited by the zero lower bound, as has been the case for decades. Many well-known economists doubted my projection. So we may end up opening a paradigm shift in economic insight…

The question remains whether the plot line will bounce off of the zero bound again as it did before the last two recessions or start heading upward toward another recession.

The movement of the plot line above can be used in another graph to signal the probability of a recession. As spare capacity starts to rise after hitting the effective demand limit, the economy rides the edge of a recession.

update recession alert

(link to graph)

When the plot drops below the yellow line, a yellow flag goes up for a recession. If the plot drops below the red line, we are in recession. The plot line dropped below the yellow line in 4Q 2012, but the economy hadn’t reached the effective demand limit yet.

Currently, the plot in the first graph has reached its effective-demand zero lower bound… and is near, but not below, the yellow line in the 2nd graph. So fingers on the yellow flag, but not raising it yet.

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No Surprise Productivity Growth is Slow

The following graph shows a pattern of productivity growth through a business cycle. The graph plots my UT index against Year over Year % change in productivity for the past 41 years. (Link to FRED data for graph, 1974 to present)

productivity gut

The UT index is a measurement of effective demand. It measures the difference between effective labor share and the composite utilization of labor and capital. The UT index is mostly a measure of spare capacity. As the UT index falls to zero, the business cycle is maturing and coming to an end. As the UT index average rises from zero, a business cycle is going through and recovering from a recession.

The orange line is data from 1974 to 2001. The high portion of the orange line where the UT index goes over 19% happened during the Volcker recession. That portion shows high spare capacity but low productivity growth. It is an anomaly because the recession was induced.

The blue line is data since 2002. The red dot near the crossing point of the axes shows the current data point for 3Q 2015.

The plot moves within the shaded area. For instance, if you expect to have productive growth of 4%, data shows that you need to have a UT index of spare capacity at least 6%. Also, if you have 0% growth in productivity, you can expect to have less than a UT index of 7%.

On the other hand, if I see a UT index of 1%, I would expect productivity growth to be between 0% and 2%. If I see a UT index of 10%, I would expect productivity growth between 2% and 5%.

The general trend is that productivity will increase when more spare capacity opens up in a business cycle.

Looking at the position of the red dot of current data (1% UT index, 0% productivity growth), there really is no surprise that productivity growth is low.

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