I am looking at a graph that should sound the alarm for all economists. We are heading into trouble if labor share of income continues to decline.
In this graph, I plot the Fed funds rate on the y-axis and the TFUR on the x-axis. TFUR, total factor utilization rate, is only the product of the utilization rates of labor and capital. (% capacity utilization * % labor force employed) The TFUR is an important part of the equation to determine effective demand.
The numbers used for this graph are solid numbers. The blue line is the actual Fed funds rate since 1988. The orange line is what the effective demand rule calculates for the Fed funds rate. You can see that both lines move within two boundaries, an upper and a lower limit, except during the liquidity trap when the actual Fed funds rate cannot go negative. In a liquidity trap, the blue line will stay on top of the zero 0% lower bound. (You can see these lines described in the previous post on this blog.)
The vertical green line is the effective demand limit that has been declining over the years. The effective labor share of income directly determines where this line is placed. I have written extensively in the past blog posts that the combined utilization rates of labor and capital (TFUR) cannot easily rise above effective labor share. Look at all the plots on the right side of the green line (above 74%). Those are now completely impossible for the economy... gone to memory and never to return unless labor share of income rises.
What does this mean? As the green line of declining labor share continues to shift left, the Fed funds rate is progressively pushed down and to the left into a zone of non-traction... a zone of the liquidity trap. It is the progressive death of the Fed funds rate. If effective labor share of income, which is now 74%, goes to 71%, the US economy would be in serious trouble. The Fed funds rate would always be near 0%. There would never be any traction for interest rates.
If labor share keeps dropping, we will have big problems. If labor share stays where it is, we will suffer a lethargic economy for years. But if effective labor share can shift right towards 80%, the Fed funds rate will be able to rise into a healthy zone leaving the liquidity trap zone behind.
This graph is a warning. Economists are aware that inequality is a problem, and this graph shows it in a very clear way.
Labor Share of Income will eventually have to rise.
(note: See most recent version of the monetary model.)