The model is simply that labor share sets a limit on the utilization of labor and capital. If the utilization of labor and capital goes above an effective labor share, capital starts consuming its own aggregate income.
Like I have said since late 2014, the Dow will orbit around the 17,300 point as an attractor state at the end of the business cycle. The Dow is at 17,230 today after falling below 16,000 in January and February.
The business cycle is still holding out. The cascading effects of recession have not started yet. They have not been sufficiently coordinated so to speak. But I stand by my view of the Dow. It can rise above 17,300, but not rise much above before another move downward would eventually happen.
I foresee the Dow peaking between 17,300 and 17,600 as the time to go defensive.
As for Monetary Policy...
The business cycle has not changed its dynamics much. There is no large bubble with expanding dynamics. Monetary policy is holding value steady as some firms hurt and other firms get strong. The idea of the Fed is to find a balance so that the economy gets healthy through a prolonged steady state dynamic.
I woke up today to see oil below $27 a barrel, the US 10-year at 1.6% and the Dow down to 15,600. How quickly the economy is faltering. It is a crazy moment.
Oil below $29 a barrel creates Geo-political tensions that can create attacks of aggression. Other countries have already tried to negotiate with the Saudis to raise oil price... and now oil is slipping to even new lows. A tense situation for oil producers.
The US 10-year hitting 1.6% so fast over the past month seems to be building up downward momentum. The yield curve is trying hard to flatten even with short-term rates near zero.
Recession seems imminent. Will it happen?
I called a recession this year based on my assessment of effective demand. Others like Tim Duy and Janet Yellen do not see a recession this year. But they lack an understanding of effective demand.
I have seen this coming for a couple of years.
Back in September of 2013, using my Aggregate Supply- Effective Demand model, I saw that an effective demand limit was forming at a Real GDP around $16 trillion (2009 $$). The AS-ED model was only developed in April, 2013.
I saw that the effective demand lines were bunching together setting up a Long-run Aggregate Supply zone around $16.1 trillion, where the aggregate supply and effective demand lines would meet.
I wrote in September, 2013...
"The blue dots along the bottom are real GDP on the aggregate supply curves increasing at an inflation rate around 2%. Real GDP will most likely continue this path over the next year, shown by lower dashed black line. The dashed black line above shows the effective demand limit coming steadily downward toward the LRAS zone. (LRAS is long-run aggregate supply). Real GDP and effective demand will meet at the LRAS zone. What will happen when they meet? ... If real GDP keeps growing at around $100 billion per quarter as it did in 2nd quarter 2013, real GDP will enter the LRAS zone in mid 2014."
The recession of 1980 followed the same pattern. The effective demand lines had been pointing toward an effective demand limit for 3 years since 1975. Then Real GDP hit the ED limit in 3 rd quarter, 1978. A recession began to form and was official 2 years later. (link)
Eventually in a post in August of 2014, I projected...
"The projection now is for real GDP to enter the zone of the effective demand limit between $16.000 trillion and $16.160 trillion. This will happen before 2014 ends assuming the calibration of 0.762 for effective labor share is within a close margin of error."
So what happened?
The red dots show that the crossing points between aggregate supply and effective demand began to rise when Real GDP hit $16.1 trillion. That is a sign of hitting the effective demand limit. This happened before the end of 2014, just as I had predicted. When effective demand rises in the LRAS zone, the dynamics of the economy are on the downside of the business cycle, just starting downward.
Ever since the end of 2014, the economy has been faltering. I predicted that the Dow would orbit 17,300 through 2015. And it did. I gave a 70% chance of recession this year back in January. (link, see comments.)
If this cycle is like the cycle before the 1980 recession, we would see a recession about 2 years after hitting the effective demand limit... That would put a recession this year, 2016, in the summer or fall.
So I got glimpses of the effective demand limit upon Real GDP as early as September, 2013. We have seen this coming for years.
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.
Tim Duy, who is a cool economist, points out a difference between the labor market and output GDP... Labor market improving while GDP is slowing. He describes this difference for the Fed.
"Now they have slow GDP growth and fast employment growth. That will make brains explode on Constitution Ave."
Yet, Brains need not explode. I have had a model of this difference for a couple of years, which predicted perfectly this situation. Yet, my model ultimately shows that the business cycle has ended, which is something economists like Duy and others at the Fed may not accept.
The Cobra Equation
The driving force behind an effective demand limit is the aggregate profit rate. When companies have increasing profit rates, it is more difficult to have a recession. We have seen in the past year that the aggregate profit rate is falling. This is not a good time to be raising interest rates. It would have been better a few years ago. Anyway...
I gauge aggregate profit rates in 3-dimensional space with what I call the Cobra equation, because it resembles a cobra in 3-D space...
Profit rate = (U + C) - a*(U2 * C2)
U = (1 - unemployment rate) C = Capacity utilization a = effective labor share2 - 2.475 * effective labor share + 2
When I take the derivative of the equation, I can gauge the potential change of the aggregate profit rates. I can take the derivative with respect to C and U.
d profit rate/dC = (1 - 2aCU2)
d profit rate/dU = (1 - 2aUC2)
They look the same but in reality they take different paths. Here are the derivatives up to December 2015.
Basically the graph shows that the utilization of capital reached its max profitability towards the end of 2014, when the red line reached zero %. Businesses have squeezed all they can from capital in the aggregate. For capital, the business cycle is over. But hiring labor is still profitable, so as the business cycle hangs on, we will see improvements in the labor market.
This model predicted perfectly the path of utilizing labor and capital. Here is a graph plotting the Cobra equation. The utilizations of labor and capital reached profit maximization, slid along the max limit, and have since backed off which is setting the stage for a recession type scenario.
The Greater Meaning
The greater meaning behind this model is that the economy has already reached the top of the business cycle and the Fed is completely behind the curve for raising the Fed rate now. They should have been normalizing the rate before the plot in the above graph reached the effective demand limit. The economy had momentum at that point to withstand interest rate rises... but not now.
The Fed should stop trying to raise the Fed rate and just let the business cycle collapse on its own. The Fed is just hastening the recession process by projecting rate increases beyond the effective demand limit.
The Fed is really messed up because they do not have a "real-time self-calibrating" measure of an aggregate effective demand limit. But we have one here... so brains need not explode. However, brains may explode once the Fed realizes they are completely behind the curve.
Update: A bit to add about slowing GDP...
This goes back to the equation for profit rate...
Profit rate = (Productivity – Real compensation) * Total labor hours/Capital stock
Increasing labor hours increases the profit rate. Whereas increasing the capital stock would tend to decrease profit rates. So when capital is maxing its use in the aggregate, we will see an aggregate drop in capital investment, which is the current driver of slowing GDP.
I wrote last summer that the Dow would not rise much above 17,300 and then eventually drop from that level into a recession. We see markets dropping now, but are they dropping into a recession or a resetion?
What is a resetion? That is when the markets "reset". Stock values have been high so at some point they need to come back to reality. Many companies have been overvalued. Now is the time to reset stock values.
The difference between a recession and a resetion is that a recession hits the whole economy and a resetion hits certain markets and business values.
In a recession and a resetion, many companies are challenged to survive and some end up fading away. Ultra-low interest rates have kept inefficient companies alive which have kept down wages and productivity. The survivors come out stronger. Productivity rises after.
We will see at least a resetion of the stock markets. But will we see a recession in the whole economy? Well, there is a need for a resetion of the whole economy too. Rent prices are pressuring the budgets of many people. Inefficient companies need to be weeded out. Asset prices beyond stocks need to reset too. So a resetion (resetting) of the whole economy could result in some healthy changes.
Most economists do not put stock in the stock market. That is to say that they do not include the stock markets in their analyses. Yet, economists should have a sense of what the markets will do if they are actually good economists.
Economists seem to think that the stock markets are ruled by psychology and irrationality. Maybe so, but they can still be understood. Economists do not seem to understand stock markets. However, Larry Summers says that economists and policy-makers should not ignore the stock markets. (link)
Tim Duy who is a respected economist stands by his prediction that there will not be a recession this year. (link) Yet he also predicted that the stock markets would rise modestly this year. (link) Who really thinks the Dow could make it back up to 18,000 this year? There would have to be massive easy monetary policy globally. Yet that would just make the markets that much more top heavy.
What economists really need is a way to measure the limits of the business cycle. I have the advantage of being able to measure an effective demand limit on the business cycle.
In 2014, I said that the Dow would orbit around 17,300 for the rest of the business cycle. Then I said last summer that the Dow would not go much above 17,300 and would eventually come down from that point into recession. After this past week, I can more easily repeat my prediction. It would take a lot of psychological healing from China to other parts of the world to bring back faith in stock markets to get the Dow over 18,000 before the next recession.
What did I do to make these correct predictions?
It is just an understanding of effective demand, which signals the natural top of the business cycle. My models are developing in order to foresee this top years in advance. I seem to be the only economist using a measure of effective demand to make correct predictions ahead of the markets. Other economists make correct predictions without using a measure of effective demand. But my point is that effective demand can be used to much easier.
If other economists are able to understand what I understand about effective demand, we might see better predictions and policies. Of course, the proof in the pudding will come if there really is a recession this year. Then my measure of effective demand hit spot on the natural top of the business cycle near the end of 2014.
Am I a great economist? No... but the great ones would be better if they understood effective demand.
Keynes emphasized effective demand in his great book, but does anyone but me put a number to it? Not that I see... and my numbers are hitting spot on... so far.
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.
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...
Data as of 4thQ-2015
Effective Demand = $17.067 trillion
Real GDP = $16.455 trillion
UT index = +3.0%
demand limit upon TFUR = 76.2%
TFUR = 73.2%
ED Fed rate = 2.6%
Estimated Natural Real Interest rate = 2.0%
There is no recession for 4thQ-2015. None expected thru 1stQ-2016.
(UT index close to 0.0% shows that real GDP is hitting the effective demand limit. UT index rose through 2015 after hitting the limit in 2014.)
Click on Graphs below to see new data by updating at FRED.
UT Index (measure of slack):
Recession Alert (developed at recessionalert.com):
ED Output Gap:
Regressed Output Gap:
YoY Employment change:
Speed of consuming slack: yoy monthly:
Speed of consuming slack: quarterly:
Real consumption per Employee:
Will real wages ever rise faster than productivity?:
Real Wage Index:
Productivity against Effective Demand limit:
Bottom of Initial Claims?:
Tracking inflation expectations:
Measures of Inflation:
M2 velocity still falling:
Double checking labor share with unit labor costs & inflation: