I have not posted in a while. I am watching the craziness as Trump turns the economy against the general population.
From what I see, inequality will grow... and importantly, negative externalities will grow and accumulate. Businesses will make more profit in the short-term, but in the medium-term, the negative externalities will burden the economy.
Here is a graph that shows the fall of core PCE inflation from its peak in 1981 to the present. (link to quarterly data)
Inflation has fallen with stable swoop downwards. We are currently at about the 0.1 mark on the x-axis showing a core PCE of 1.6% on the y-axis.
The graph implies that inflation is a long way from returning back to the conditions when inflation was high. So the x-axis must tell a story of inflation. What is on the x-axis? Let's look at its equation...
Profit per unit of real gross value added of nonfinancial corporate business: Corporate profits after tax with IVA and CCAdj (unit profits from current production) - (60%*Fed rate +40%*10-year treasury rate)
The equation basically takes the real after-tax profit rate and subtracts a measure of the nominal rate which blends short-term rates with long-term rates.
When nominal rates are high, we would expect inflation to be high too. Why? Well, when inflation goes high, nominal rates go high to control inflation. But there is more to the story. Nominal rates can float inflation upwards, or knock it down depending on how strong nominal rates rise.
Model of Inflation & Nominal Rates (Cat & Mouse Chase)
Here is the model for the graph. The upsloping red diagonal line is the real cost boundary. Corporations want to be to the right of this red line. Then their after-tax profits are positive and the economy can grow or stabilize. But to the left of this red line, corporations are forced to contract from negative after-tax profit rates.
Net Profit rate = real profit rate - nominal rate + inflation
If corporations can keep prices rising ahead of nominal rates, then they can deal with profit rates being squeezed. But if the central bank does not like rising inflation, nominal rates will get aggressive and can force net profit rates negative. This happened in the Volcker recession. As soon as Volcker jacked up the Fed rate, the data points were pushed to the right of the red diagonal line and the recession ensued, which brought down inflation.
In the model above, the black arrow shows that inflation rises when nominal rates are rising but not strongly enough and inflation can keep ahead of it. Then when nominal rates get aggressive, we follow the dashed red arrow to the left side of the real cost boundary. Then we follow the green arrow down, where inflation is dropping and nominal rates can follow them down.
I view the dynamics like inflation is a mouse and nominal rates are a cat. If the mouse can stay ahead of the cat, the mouse will keep moving in the same direction. If the cat can get ahead of the mouse, the mouse will turn around and head back in other direction.
Currently we are far from the red diagonal line. Real profit rates are at historic highs and nominal rates are low. Yet, people think that inflation will shoot up soon because nominal rates are going up and profit rates are coming down. So corporations will have to react with price increases.
However, real after-tax profit rates will have to come down much farther, and nominal rates will have to rise much further. My view is that real after-tax profit rates may actually rise if corporate taxes are slashed last year. As well, the Fed will most likely raise the Fed rate slowly as Stan Fischer has stated.
Since the model above sees very low inflation pressures for years, the Fed will be justified in raising the Fed rate slowly. Ultimately, bond yields will come back down from the recent increases.
Last week the markets moved. Bonds yields went up. Stocks went up. Inflation expectations were awakened.
What will the Fed funds rate do? How might the Fed respond?
I will do an analysis to project a path for the Fed Funds rate based on my research into effective demand. (a synopsis of the research.)
Effective demand is basically a limit upon the utilization of capacity determined by labor share. As labor share falls, the optimal utilization level of capacity also falls. We have seen labor share fall. At the same time capacity utilization trended lower. My research into effective demand is built upon the following graph.
Profit Rate Cycle
The original description that Keynes and others gave for effective demand pointed to profits as the driving factor. Once entrepreneurs see profit rates peaking, they will stop utilizing labor and capital because if they did, profit rates would decline.
My models of effective demand track the profit rate cycle. (link)
The profit rate cycle tracks the business cycle. The following graph gives a profit rate based on profits in relation to GDP. (link to FRED data)
The profit rate rises and then falls in each business cycle between recessions. It would appear that this business cycle is nearing its end.
Markets after Trump Victory
As I started this post, I mentioned the moves in markets during the last week. There is revived hope of getting the economy going again. Trump promises fiscal expansion, deregulation and lower taxes. In short, there's seems to be a business expansion being revived using supply-side strategies.
It is not common in the profit rate cycle (graph above) for profit rates to climb back up to two major peaks before a recession. But let's assume that this business cycle can be revived without a recession taking place. What might that look like?
Path of Labor & Capital
In the model of effective demand, capacity utilization is optimized at the effective demand limit. Profits from the utilization of capital are maximized. Entrepreneurs see that profits cannot be extended, so utilization of their capital is held back.
But what about the utilization of labor? Labor is used only in order to optimize capital. The priority is to maximize capital. That is how profits are maximized. Labor actually eats into profits. So there is a dance between labor and capital, where capital is actually leading where labor goes.
The following graph tracks the path of utilizing labor and capital. Once the path hits the effective demand limit, capacity utilization will either stop rising or fall. It fell in this business cycle. I predicted this in 2013 before it happened in 2014.
So now I look at this graph and ask... Where can this path go now assuming that the business cycle is being revived?
One thing is for sure, the unemployment rate cannot rise. That would trigger a recession and end the business cycle. So unemployment either has to stay around 5% or go lower. Then capacity utilization would have to start rising. I will assume that unemployment can go down to 4.5% while capacity utilization goes up to 78%. That would take the path back to the effective demand limit with increased utilization of labor and capital.
Projecting a Path for the Fed Rate
I have been lightly touching upon the forces that shape the business cycle so far. Mainly there is a profit rate cycle based on optimizing capital which is impacted by labor share as an effective demand limit.
The Federal Reserve would like to have monetary policy guide the business cycle into full-employment while stabilizing inflation around a target.
My research has a model for describing the best Fed rate path based on the effective demand limit and the accompanying profit rate cycle. (link) Basically the Fed rate needs to be normalized at the effective demand limit. Normalized means that the Fed rate equals the inflation target plus the natural real rate of growth in the economy. Currently the inflation target is 2% and the natural real rate is estimated around 2%.
Here is my estimation of the natural real rate which is based on my estimation of potential GDP.
The natural real rate changes as economic conditions change. The natural real rate normally peaks around the peak of the profit rate cycle. I will assume that the revival of the business cycle taking place at the moment raises it to 2.5% which is still below the previous peak and honors the business expansion expectations currently taking place.
So now I plug into the model the numbers needed. Optimized capacity utilization = 78%. Unemployment = 4.5%. Natural real rate = 2.5%.
The model kicks out an equilibrium inflation target which the economy would find easier to maintain. In the past recent years, the model kicked out an equilibrium inflation target below 2%. But now it kicks out an equilibrium inflation target of 2.3%. This means that inflation potential is rising with the selected parameters.
Here is what the model forecasts.
Let's start the analysis with the vertical green line which is the effective demand limit. It sits at 78% of capacity utilization. That is where capital will be optimized. Next, the normalized Fed rate would be 4.8% based on a natural real rate of 2.5% plus an equilibrium inflation potential of 2.3%. (Inflation potential is rising with the projected plans for fiscal policy. The Fed would have to push the Fed rate a bit higher to control inflation.)
Next, the solid orange line shows the path of the Fed rate to normalization (red dot) when capital is optimized. It currently sits near the zero lower bound with a capacity utilization near 75%. The path upward is measured by increases in capacity utilization.
The solid yellow line shows a projected path for inflation potential. The model shows that core inflation could reach 3.2% at normalization. Inflation potential would increase. So the Fed might have to raise the Fed rate a bit faster to control inflation.
The path is steep upward depending on how fast capacity utilization can rise. Stan Fischer of the Federal Reserve says rates need to go up gradually. So if capacity utilization goes up gradually, everything should be alright. However, there is a possibility that the Fed rate will need to go up faster than some at the Fed are prepared for depending on if the fiscal stimulus is aggressive.
If the Fed rate rises too gradually in relation to capacity utilization, one might expect a bubble to form somewhere or inflation to push upward faster than wanted.
Now it may seem pretty crazy for a model to project such a steep path upward. Yet, the IS-LM model gives a similar view of how this happens. At the end of a business cycle, the LM curve can be steep or vertical.
The figure shows that as the IS curve shifts rightward due to strong fiscal stimulus, interest rates rise (r1 to r2), but output really does not. My model has a method to optimize the x-axis with effective demand to show where the "LM" curve goes vertical.
I see trouble ahead. There are forces ready to push inflation and interest rates up, but the effect upon real GDP will be disappointing.
Economists do not have a measure of an effective demand limit. My research is unique. So they would not expect the renewed expansion to end so abruptly. That will create confusion. I foresee frustration between the government and the Federal Reserve.
The problem rests in that the business cycle is already in its dynamics of ending. The Fed rate has gone way behind the curve letting the business cycle develop more zombie soft spots than normal. Zombie soft spots drag down net economic benefits to society. So the economy is sensitive to the discipline of higher interest rates in a negative way.
This graph shows yoy %change for the U-3 and U-6 rates for unemployment. (link)
They are on a normal trend of a business cycle where they bottom out and then head upwards. When the trend starts to go positive, a recession is imminent. The trend is just now hitting 0% which in the last two business cycles signaled a recession about 3 to 9 months ahead of time.
Many think that effective demand is simply aggregate demand. But that is not true. They are different concepts. It is very important in the current economic sickness to understand the role of effective demand. So I will define effective demand in this post as Keynes saw it.
1. Effective Demand is not Aggregate Demand
Don’t confuse the AS-AD model with effective demand. The common AS-AD model puts AS = AD at any point in time. The lines always cross. What is consumed equals what is supplied. That is in agreement with Say's law.
When Keynes defined the concept of effective demand, he did not describe the AS-AD model where you have price level on the y-axis and real output on the x-axis. (see Chapter 3 of Keynes' General Theory) Keynes' model put demand above aggregate supply at any point in time. Demand above aggregate supply gives entrepreneurs incentive to employ more labor and capital. The difference between demand and aggregate supply gets smaller as more labor and capital are utilized. So imagine two lines that meet at some distant point. One line is demand above the other line of aggregate supply. But the demand line is not aggregate, but rather effective demand. The point at which these two lines meet is the effective demand limit upon full employment.
Here is the model I use for how Keynes described effective demand.
I put price value on the y-axis to show what is supplied and demanded. But on the x-axis I put the utilization of labor and capital. The x-axis represents how the economy grows by utilizing more labor and capital. As you move right on the x-axis, you utilize more labor and capital with the demand line higher than the supply line. Eventually you reach the equilibrium point between supply and demand. The equilibrium point is where Keynes defined effective demand. It is where you will find your full employment level for utilization of labor and capital. Therefore, the point where the two lines cross is the natural level of real output. That is the effective demand point that Keynes describes….
If we see the crossing point as stationary, then as you employ more labor and capital beyond the point, effective demand will go below what entrepreneurs will supply. Then entrepreneurs will un-employ labor and capital because they see their profit rates maximize.
So the normal model has AS and AD moving together. In Keynes model, the economy is moving toward a “fixed” long run equilibrium state between supply and demand.
(note: The difference between the aggregate supply and effective demand lines measures the spare capacity in the economy in terms of both labor and capital.)
2. Effective Demand is based on Labor's Share of National Income
For me, the line of effective demand is determined by labor’s share of national income in relation to the utilization of labor and capital on the x-axis… Not by labor’s total income, but by labor’s % share. You can actually change labor's total income without changing its share.
3. Shifts of the Effective Demand line
The effective demand line can shift when labor's share changes. An increase in labor share will shift the effective demand line upward. The equilibrium point shifts up and right along the aggregate supply line allowing more utilization of labor and capital at a higher natural level of real output.
4. Shifts of the Aggregate Supply line... Productivity Increases
The aggregate supply line will shift up and down too. If productivity increases, output per utilization rate of labor and capital rises, and we see the AS line shift upward. Yet the result is to shift the equilibrium point of effective demand to the left, thus lowering the natural level of output in terms of utilizing labor and capital. Thus productivity increases are not possible when the economy is near the equilibrium point. Entrepreneurs would want to un-employ labor and capital.
That is why the data shows that productivity will stabilize when the economy is near the effective demand limit. So the productivity conundrum is no mystery, when effective demand is properly understood.
This graph shows productivity stalls against the effective demand limit. When the line in the graph moves away from the ED limit, we see productivity increases. That is when the utilization of labor and capital is to the left of the equilibrium point in the model given above.
5. Vertical Shift of Equilibrium Point
Look at the graph of productivity. Find the points for 1994 through 1997. Productivity did not move for 4 years against the ED limit. But then look at how the plot moved up along the limit for a couple years before the 2001 recession (0.73 to 0.80 range). So I ask... How was productivity able to increase at the ED limit? Wouldn't the equilibrium point move to the left and shut down utilization of labor and capital?
The answer is that the equilibrium point in the model shifted up vertically.
As productivity increased, effective demand had to increase at the same time. How did this happen? Well, labor share rose during that period of time, which shifted the effective demand line upwards.
(Note: The utilization rates of labor and capital had to stay steady in order for the equilibrium point to rise vertically. So as unemployment fell during that time, we saw capacity utilization fall too. As more labor was employed, less capacity had to be employed in order to not go beyond the profit maximization point of the ED equilibrium point.)
6. Drop in Potential GDP after the Crisis
After the crisis we saw labor share fall.
The effective demand line in the model shifted downward thus moving the equilibrium point of the natural output level down along the aggregate supply line. The y-axis then tells us that potential GDP declined. The x-axis then explains the higher unemployment rate and the lower capacity utilization rate that we see. Once you understand effective demand as Keynes saw it, the drop in potential GDP and the rise in the natural rate of unemployment is no mystery. But the CBO is slow to understand this.
7. Looking at Current Effective Demand
This chart has the most recent data on effective demand. (1Q-2014)
Productivity is stalled. Profit rates have peaked. There is very little spare capacity left as the lines are very close. We are at the effective demand limit. Full employment now sits at a lower level. Even the Fed may be realizing this.
Keynes defines effective demand as a distinct equilibrium point and not an infinite range of values along the aggregate supply curve...
"For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of the proceeds over the factor cost."
"The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.
"The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. ... The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.
"If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment.... Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile."
I am helping to write that vitally important chapter. Economists must understand effective demand as Keynes saw it. There are a lot of futile discussions abounding out there.
UPDATE: What stops productivity from just rising up the "slope of 1" line in part 4. This graph shows the answer. Increased productivity shifts the aggregate supply curve up. As the equilibrium point moves left, profit rate maximization moves left too. Thus firms trying to maximize profits would be forced to un-employ labor and capital if they tried to raise productivity against the effective demand limit.
Janet Yellen gave a speech where she posed 4 questions to economists in general seeking answers... The first question she asked was this...
"The Influence of Demand on Aggregate Supply The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?
"Prior to the Great Recession, most economists would probably have answered this question with a qualified "no." They would have broadly agreed with Robert Solow that economic output over the longer term is primarily driven by supply--the amount of output of goods and services the economy is capable of producing, given its labor and capital resources and existing technologies. Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the mostly exogenous supply-determined longer-run trend."
Janet Yellen is really asking for research into effective demand. She sees a weakness in aggregate demand affecting aggregate supply... or potential output. That is effective demand, but she cannot even use the term effective demand because economists do not understand it.
I have been researching effective demand for 4 years. I have seen really a complete lack of understanding of what effective demand is among economists. It surprises me that Janet Yellen would be calling for research on its dynamics.
She does not really understand effective demand yet though. She goes on in her speech about hysteresis which is a short-term shock which produces a long-run affect. Effective demand is not a short-run shock. It is based on the relative strength of labor share to profit share. A lower labor share sets a lower limit upon potential output. And the drop in labor share is not short-term. It has been constant for years since the crisis.
I have models that can be built on by other researchers. It truly is important for economics to finally understand and define effective demand.
Many top economists use the IS-LM model to support low interest rates. The LM curve of the IS-LM model is built upon a model of financial markets.
In the graph above, money supply has been pushed far to the right to keep interest rates low. The model implies that the money supply would eventually have to be reduced in order to raise interest rates, but the Fed has other ways to raise interest rates.
But there is a glitch to pushing the money supply so far to the right. Low interest rates help unproductive firms stay in business. And we have had low interest rates for years now.
What is the glitch?
There are more unproductive firms doing business... and the economy has become dependent upon them. Not good...
The Wall Street Journal had an article showing how inequality is growing between identical workers, because productivity differences between firms even in the same industry have widened. (link) So there is evidence that low productive firms have become more prevalent.
Creative destruction is an important part of a proper interest rate cycle. Proper interest rates keep low productive firms at lower levels. These low productive firms drag on productivity, wage growth, investment and potential growth. A higher prevalence of unproductive firms supports the case for low interest rates. But the purpose of low interest rates was not to increase unproductive firms but to keep them from crashing too fast. Now they are not being allowed to crash at all. Thus, the glitch.
An efficient economy where resources are allocated to maximize net social benefits must have a proper interest rate cycle for creative destruction.
The Fed missed the interest rate cycle this business cycle, so the prevalence of low productive firms has increased. It will be very difficult to raise interest rates because the economy now depends on these low productive firms.
A rise in interest rates will push many unproductive firms over the edge and start a cascading downward of the economy. The economy has become more sensitive to interest rate hikes due to an increased prevalence of unproductive firms.
Interest rates will have to go through a properly disciplined cycle to get the benefits of creative destruction. Or the unproductive firms will be pushed out anyway as profit rates decrease at the end of this business cycle. Either way, there will be pain for some.
Larry Summers wrote a post yesterday about the hollowing out of the middle class and how that has lowered consumption and led to secular stagnation. He says that this effect must be taken into account for policy.
Well I sit here after 4 years of building models of Effective Demand using labor share... My models have performed accurately. Keynes described Effective Demand in his great book.
Keynes defined effective demand as a limit on expected profits by entrepreneurs. At the effective demand limit, profits are maximized and utilization of resources starts to be cut. My models predicted in 2013 that the profit cycle would peak in late 2014. And they did. There is an effective limit upon the biz cycle from demand.
The drop in labor share reflects the hollowing out of the middle class. The data for labor share allows precise models to be built for secular stagnation. Larry Summers is absolutely right when he paints a basic picture of policy implications...
"What is the policy implication? Principally, it is the macroeconomic importance of supporting middle class incomes. This can be done in a range of ways from promoting workers right to collectively bargain to raising spending on infrastructure to making the tax system more progressive. These are hardly new ideas. And I supported them before seeing this new research. But there is now another powerful argument in terms of mitigating secular stagnation in their favor."
Larry Summers sees new research, but I have seen 4 years of economists not understanding effective demand. So when I see Larry Summers' post, I again see how far behind economics is in truly understanding the dynamics of effective demand. He notices a connection between labor income and economic potential, but has no model to define it yet. I have a models of effective demand that work and that can be built upon.
From my models, the effects and limits of effective demand are definable and forecastable in terms of labor and capital utilization and more such as interest rate policy. My models show that the effect on natural real rates from a drop in effective demand can be measured.
Larry Summers has not said it yet, but corporate after-tax profit rates will have to drop.
Also, my models show that the Fed missed a whole interest rate cycle and they do not even know it yet. They still think the cycle is just beginning. That shows how much an understanding of effective demand is lacking. It is a serious issue.
Larry Summers does not have precise models yet for effective demand, but he has opened the door to knowing.
Data as of 4thQ-2016
Effective Demand = $17.587 trillion
Real GDP = $16.805 trillion
Productive Capacity is rising to next business cycle =
UT index is rising = +3.9%
demand limit = 75.9%
TFUR = 72.0%
ED Fed rate rule (down from a peak of 3.8% in 2014) = 1.6%
Estimated Natural Real Interest rate = 2.2%
Short-term real interest rate (fallen from 2.8% peak in 2014) = -0.5%
There is no recession for 4thQ-2016. I am expecting a recession by the middle of 2017.
(UT index is rising which implies a recession is on the way.
Click on Graphs below to see updated data at FRED.
UT Index (measure of slack):
z derivatives in terms of labor & capital:
Effective Demand, real GDP & Potential GDP:
ED Output Gap:
Corporate profit rate over real cost of money:
Exponential decay of Inflation:
Measures of Inflation:
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:
M2 velocity still falling:
All in one:
Double checking labor share with unit labor costs & inflation: