This post is going to "try" to explain why the Fed rate should be as high as 3% now. But I need to explain the model from the ground up...
The Basic Graph
The basic graph puts the interest rate on the y-axis and the utilization rate of labor and capital on the x-axis (TFUR). TFUR is simply multiplying the capacity utilization rate by the employment rate. The employment rate is simply 1 minus the unemployment rate.
It is obvious to put the Fed funds rate on the y-axis because we want a model to determine it. But why the TFUR on the x-axis? Well, we really want the Fed rate to be a function of the utilization of labor and capital. We can see in the basic model above that when labor and capital have low utilization rates (TFUR low), the Fed rate (blue line) goes lower to lower the cost of money for lending and such. As the TFUR increases, the Fed rate increases to raise the cost of money to keep a balanced control over inflation and the risks of "reaching for yield" if the returns of safe assets stay too low.
We also see in this graph that the path of the Fed rate (blue line) crosses the 0% axis. To the left of that point it is negative and to the right of that point it is positive. The Fed rate can never go negative (even though it has at special times in history). So the Fed rate is ineffective where it goes negative. And then in the area where the Fed rate is positive, it is desired that the rate be effective in a moderate range let's say between 1% and 8%. So we would like to position the positive side of the path of the Fed rate (blue line) so that it is over the normal range of the TFUR through the business cycle.
Building a Solid Framework
Since we would like to position the moderate positive range over the TFUR as it moves through the business cycle, we need to construct a framework that will achieve this goal. So first we need to know the framework in which the TFUR moves. The framework is established by the labor share of income according to the principles of Effective demand.
When the Fed rate is low, entities of capital ownership more easily receive money in order to employ labor and capital to increase production. As labor is increasingly employed, there is more income for purchasing production and then those who own capital can receive more money to increase production even more. Labor share of income is the foundation and potential of liquidity for consumption. Labor share becomes a critical part of the equation to determine the Fed rate, because the potential of labor liquidity complements and limits the effectiveness of capital liquidity.
The basic equation of Effective demand multiplies real GDP by the ratio of labor share of income to the TFUR...
Effective demand = Real GDP * effective labor share/TFUR
As Keynes first noted, real GDP will not want to rise above effective demand. As such, the TFUR will not want to rise above the effective labor share. According to the equation, if TFUR rose above effective labor share, real GDP would rise above Effective demand. We see in the data that the TFUR does not readily rise above effective demand. (See graph of UT index in upper right corner of this blog site. As the UT index stays above 0%, TFUR is seen to stay below effective labor share.)
The liquidity of effective demand based upon labor's share of income is essential to the framework for a viable monetary policy.
With this groundwork laid for labor share, we can begin to construct the framework to position the Fed rate path over the TFUR. We now look at the equation for the path of the Fed rate...
Path of Fed rate = z*(TFUR2 + els2) - (1-z)*(TFUR + els) - inflation rate
The Fed rate is a function of the TFUR, effective labor share (els), a variable constant (z) and an inflation target. This equation matches with past Fed rate data.
The path of the Fed rate will follow the TFUR (total factor utilization rate) through the business cycle including up to the limit where real GDP equals effective demand. Knowing the top end where the TFUR is limited will help us greatly in being able to position the Fed rate over the range of the TFUR.
It is easy to obtain an equation for the effective demand limit. We only set the TFUR equal to the effective labor share (els) in the above equation. And we get this...
Effective demand limit for Fed rate = 2*z*TFUR2 - 2*(1-z)*TFUR - inflation target
We now graph these two lines. (This graph uses a standard inflation target of 2%.)
This graph assumes an effective labor share of 80%. The two lines will always cross at the effective labor share rate. We can now see that the Fed rate will be effective from a TFUR of 67% to 80%. If the TFUR moves within this range from business cycle to business cycle, the Fed rate will be effective. If the TFUR does not move within this range, the Fed rate will be ineffective.
(note: The LRAS curve sits where the two lines cross. If the TFUR reaches this vertical LRAS curve, production is said to be at full-employment within the constraint of effective demand as determined by labor share of income. If attempts are made to increase production at this point, the result would normally be inflation, not increased production. The Fed rate will then increase up the LRAS curve to control inflation.)
But we left out one part of the equation... the z coefficient. The above graph uses a z coefficient of 58.2%. What if we used a z coefficient of say... 57%? ... (2% inflation target again)
The upper limit of the TFUR (80%) is still intact, but the lower limit is now only 75%. In this case, the Fed rate would be effective over a range of only 5%, a much smaller range of the TFUR. It is unlikely that the TFUR will move within this narrow zone during a business cycle. Which means that the Fed rate would be ineffective during recessions when the TFUR falls below 75%. We need to realize that the TFUR fell to 61% during the last crisis. We can conclude that with an effective labor share of 80%, a z coefficient of 58.2% would be much better than 57%.
How can we more scientifically determine an appropriate z coefficient? I would use the following equation, which is based solely upon effective labor share (els) and the TFUR (total factor utilization rate). These are the two variables that calculate effective demand from real GDP.
Reflective Fed rate curve = els*(els - TFUR)/(1 + TFUR)
This neat little equation takes the pure relationship between effective labor share (els) and the TFUR and puts it into terms of the Fed rate. The use of this equation will make the framework we are building very solid. We now include this equation in the framework.
I call this curve the Reflective Fed rate curve because it reflects the Fed rate path curve. The reflective Fed rate curve crosses the x-axis at the LRAS curve. It also crosses the Fed rate path at the TFUR where the effective demand limit crosses the x-axis. But it is where the Reflective Fed rate curve crosses the effective demand limit curve that is of special interest. A rule of thumb is to set the z coefficient such that these lines cross at around 2% with a 2% inflation target. The result is a basic framework for an effective monetary policy.
Update 5/24/13: Some say, like Laurence Ball, that a 4% inflation target would be better than 2%. My response is that if you raise the inflation target, the path for the Fed rate drops and you actually end up with a more narrow range for effective monetary policy. Also the z-coefficient can be adjusted to whatever inflation target you want and the path of the Fed rate in the above graph would essentially not change anyway. The framework above shows that the inflation target is not the only answer to a vulnerable monetary policy. Another option is to choose whatever inflation target you want and then position the path of the Fed rate over the anticipated range of the business cycle maintaining a moderate range of Fed rates in reference to the effective demand limit. Then you will be assured that monetary policy will have an effective range for the business cycle. It is most important to have an effective monetary policy over the range of a business cycle. Business will adjust aggregate unit labor costs and keep expanding with available effective demand. The above framework would provide an effective monetary policy because it corresponds to the utilization of labor and capital in a real business cycle. Other policies like fiscal, can be used to complement this framework.
The Labor Share of Income is the Anchor
Normally throughout the years, labor share of income was fairly constant. Labor share acted as the anchor for the framework by establishing an upper limit from which the effective range of the Fed rate could set. As long as labor share didn't move a lot from its anchor point, the framework could encapsulate all business cycles. Also, the z coefficient was able to stay steady around the 58% to 58.4% range. The inflation target could adjust without upsetting the framework, because a change in the inflation target simply moves the curves up and down within the effective range.
The problem we have now is that labor share has fallen a lot to 74% and there is no mechanism, nor policy working to return it back up to around 80%. If we use the same framework that we used for many years, this is what our current monetary policy looks like.
As you can see, the effective range of the Fed rate is extremely small. Just as soon as the Fed rate starts to rise, the economy will hit the LRAS curve. And inflation could be a problem if there are large increases in lending and liquidity for consumption. But we will still have low utilization rates of labor and capital. So it may be hard to generate inflation.
So if labor's share of national income does not change, monetary policy is effectively dead.
What happened to our framework?... Our effective labor share anchor has moved. The graph above shows that the point where the Reflective Fed rate curve crosses the x-axis fell from 80% to the current effective labor share rate of 74%.
Let's take a quick look at past data for the Reflective Fed rate curve. This is data from 1975 to the end of 2001.
We can see from the trend line that effective labor share simply did not change much for all those years. If it did change, it always tended back toward a rate of 80% when the economy reached the effective demand limit at the LRAS curve. An effective labor share of 80% was the anchor for the monetary framework... and it served us well for many years but not now...
Now we look at what has happened since the crisis of 2008. Labor share is trending on a completely different line toward an "effective labor share" anchor of 73.4%.
What does this mean? It means that the framework within which monetary policy operated for years has shifted. We now must move the anchor of our monetary framework to 73.4% And we can see 3 graphs up that an effective labor share of 74% does not give an effective monetary policy using the old framework. If labor share had never fallen, monetary policy would still be operating within the former framework... and the Fed rate would be between 2% and 3% at the moment.
Important: If you can see ahead of time that your effective labor share is going to anchor at 74% from the trending line shown above, it is simply wise to position your monetary policy framework around that effective labor share anchor. You know where the framework has to be positioned. This also means setting the LRAS curve at 74% and then adjusting the z coefficient so that the Fed rate path has a sufficient effective range to the left of the LRAS curve. Then as the economy expands, the Fed rate will increase effectively to the LRAS curve.
Think of the labor share as the anchor on your boat. You are going to drop anchor in a bay for the night. If you drop anchor in shallow water, when low tide hits your boat will sit on the sand and could be damaged. If you drop anchor in deeper water, your boat will be fine when low tide hits. The tide has shifted downward overall, and the Federal Reserve is still anchored at the same point. Thus they are now stranded on sand. They need to move their boat to where the tide has gone to. The level of labor share is a crucial dynamic to the level of the tides.
The Case for a Higher Fed Rate
Now, let's assume that labor share is not going to rise, because unemployment is high. In addition, we see that effective labor share is going to anchor in at 74%. How do we shift our framework? We change the z coefficient so that the effective range of the TFUR goes from 60% up to the 74% of the LRAS curve. This range is very wide in case there is another crisis. A z coefficient of 60.6% would work. It looks like this...
This extreme example of a very wide effective range would currently prescribe a Fed rate around 5% (see red dot at current TFUR of 72%). If the Fed had shifted the framework during the recovery, we would have had a rising Fed rate since the bottom of the crisis, where the TFUR reached 61%.
Now I can hear many people saying this is absolutely crazy. "The economy was on the verge of a depression. We have to have a Fed rate as low as possible and we have to continue with QE. If you raise the Fed rate now, the economy will stall out and crash."
First, the Fed must massively increase the reserve balances in order to protect the liquidity between banks. The Fed funds rate would slowly rise during the recovery. Banks adjust their lending accordingly.
Some economists say there is still much spare capacity available, so the Fed rate needs to be low. But they are thinking that the TFUR would rise back up to 80%. This model shows that the TFUR, utilization of labor and capital, would rise only back up to 74%. By expecting the economy to rise so much further, they calculate the benefits from low interest rates outwweigh the costs. But if they were to assume an upper limit of 74%, instead of 80%, they would see that the costs outweigh the benefits from keeping the Fed rate at the zero lower bound (ZLB).
We have a problem currently where the interest rates of central banks are so low, that less people want to invest in safe assets. In effect, savings accounts currently give no interest on deposits. People will "reach for yield" and demand more riskier assets. The returns on those riskier assets declines from increased demand to the point where the risk is greater than the return. We are now seeing global risks mounting from investors looking for higher returns. The solution is to raise the interest rates of the central banks so that safe assets become more desirable.
When an economy is coming close to the effective demand limit, profit rates slow down. It is as this point that investors start to "reach for yield" or worse drive up asset prices in an attempt to create ungrounded return on investment. The best policy is to have a viable monetary framework throughout the business cycle, which is more reason for a central bank to adjust its framework as I show above in order to have an effective interest rate.
My view is that we will still have a near 0% Fed rate when the next recession hits, and labor share may collapse even further. Then, there will be even more reason to shift the monetary framework. Otherwise, the Fed rate will be near 0% for a long time, and the increased risk from investors "reaching for yield" will always be a source of instability.
Also, I have calculated that the natural rate of unemployment has risen to around 7% during the recovery. On that calculation, it is dangerous to loosen monetary policy for a lower unemployment rate that will not transpire.
Also, take a moment to look at the broader context of monetary policy. Labor has little liquidity, while capital is enjoying money at low cost in huge amounts. This is very damaging to the economy and must be controlled. The stock market is hitting all time highs, while labor income has actually fallen since before the crisis in real terms. Corporate profits are hitting records, while unemployment still sits at 7.5%. Liquidity is plentiful among those who own capital, while constrained among much of labor. Obviously monetary policy is producing too much liquidity for those who own capital. It would have been better to raise the cost of money so as to curb the eventual excess liquidity among those with capital. Raising the Fed rate would have raised the interest earned on savings accounts, and many people would have felt more confident to spend. A small but important factor to raise liquidity for low and middle incomes.
It is not the fault of the Federal Reserve that the liquidity is not reaching labor. Yet it is the fault of the Fed that those with capital have too much liquidity. The situation will become very destabilizing as we move into the future, unless the Fed can get control of monetary policy.
If labor share does not rise, eventually monetary policy will have to operate within the new framework associated with a z coefficient around 60.6%. The Federal Reserve may never understand that they need to make this shift. They may never be able to accept that the US has become like the Latin American countries with their low utilization of labor, low labor share and liquid privileged class. It's not the traditional american way.
I lived in Chile between 2005 to 2010. The rich could borrow money for purposes of private consumption at rates from 3% to 5%. The grand majority of the people had to accept rates from 22% to 32%. I saw one bank offer a consumer rate 16%, but within a couple of weeks it was back up to over 20%. Chile provides a picture of unbalanced liquidity.
The interest rate of Chile's central bank dropped to 0.43% in August, 2009. It is now up around 5.0%. I have made a graph estimating the framework for monetary policy in Chile.
If the United States was Chile with such low utilization rates of capital and labor, many would say the economy was severely depressed... and that we should keep the central bank's interest rate at zero to promote growth. Many would be calling for massive QE in Chile. The economic situation would be unacceptable.
Would you expect the TFUR in Chile to rise up to over 70%? I wouldn't. I wouldn't keep the central bank rate at 0% in Chile. I know that the LRAS curve sits much lower.
The monetary policy in Chile wouldn't make sense if you're an American. How can they raise the central bank rate when there are huge portions of the population that need monetary help? Shouldn't they be lowering the central bank rate? The answer is that these people are outside of the liquidity flow of monetary policy. These people are not even considered in the scope of monetary policy. Whereas in the United States, we think that monetary policy will make everyone's life better. Maybe in the past that was true, but that thinking is now a delusion. Large portions of labor and capital have become marginalized in the US, and economists simply don't seem to understand that.
My point is this... Compared to the United States, the Chilean economy operates with a lower effective labor share. They have a higher natural rate of unemployment. And they have a central bank interest rate of 5%, well above 0%. Why doesn't their economy come crashing down? Wouldn't the US economy come crashing down if we raised the Fed rate in such a depressed economy?
The answer is because their monetary framework is built around a realistic range of the TFUR, as depressed as it may seem to us. The point I am making is that we need to build our monetary framework around our economy, as depressed as it may seem. It is not going to get better as many think. The potential real GDP is not still trending from the bubble years. That high trend line is a delusion.
In Chile, their monetary framework is focused on the liquidity flows of those who own capital. It would be silly for Chile's central bank to have a mandate to lower unemployment with monetary policy. Monetary policy has no effect on raising labor's share of income. Likewise, it is becoming silly for the US Federal Reserve to have a mandate to lower unemployment for the same reason. Liquidity flows among the rich while real wages stagnate.
The United States has become more like Chile's economy. There is high inequality in Chile, and inequality is increasing in the US. Monetary policy must now focus on the liquidity among the rich, who in this moment have too much liquidity. Corporations are able to borrow at very low rates for whatever reason. Ordinary people don't have that luxury. The situation is destabilizing.
I'll just end by saying that the US economy is fragmenting fast, and the Fed rate needs to rise in order to balance the economy and ameliorate the risks of the ZLB. There are false hopes that extra liquidity will help ordinary people. The monetary model of effective demand is showing that a rate of 2% to 3% would be sufficient. And then if we can find a way to raise labor's share of income, we could get out of this mess.