In the previous post, I wrote about how inflation is a game of cat and mouse between the prowess of consumers' liquidity and firms' prowess to respond with products. I presented the equation for inflation's tendency to rise or fall...

Inflation tendency = liquidity prowess of consumer dollars/production prowess of firms

- If the numerator and denominator are equal, then inflation will be constant. (Inflation tendency = 1)
- If liquidity power of consumers is stronger, then inflation will tend to rise. (Inflation tendency > 1)
- If production prowess of firms is stronger, then inflation will tend to go lower. (Inflation tendency < 1)

I want to ge much deeper into what moves inflation. I will come back to this equation later, but first, a look at inflationary gaps.

Inflationary gaps define the top side of a business cycle, when real GDP is closer to its natural limit determined by the effective demand limit. It is called the inflationary gap because inflation occurs with it, or at least that's the way it was in the past. In the effective demand research, the inflationary gap occurs when capacity utilization is more than effective labor share. The downside of the business cycle is called the recessionary gap, but I might call it the anti-inflationary gap.

Graph #1.

In graph #1, the yellow dots identify the inflationary gaps, when capacity utilization (blue line) is higher than effective labor share (tan line). You can see that inflation (yellow line) increased after the peak of the inflationary gaps in the 1970's. Inflation also fell in the recessionary gaps (anti-inflationary gaps). But inflation rose just a little after the inflationary gaps in the 1980's, and barely at all for the last 20 years.

Why did inflation stop occurring with inflationary gaps?

The answer is related to two factors, among others, but I will focus on two.

Above I presented an equation for the tendency for inflation to rise or fall. Well... How do we know who has more prowess in the market, consumers or firms? The measurement I use comes from what I call the optimal level of the Super macroeconomic potential GDP. (If you want to read about it, here is the link. The explanation is wonkish.)

Here is the equation to use...

The equation gives the optimal level of capacity utilization (cu*) at any moment for the economy. The independent variables in the equation are effective labor share (els), real GDP (Y) and a business cycle amplitude constant (a).

Since capacity utilization rises and falls through the business cycle, the optimum point should be in the center of the business cycle, where capacity utilization is equal to effective labor share. If effective labor share is on balance above the optimal capacity utilization, capacity utilization will be over optimal. Thus, when labor share is too high, the implication is that the prowess of labor's liquidity will be greater than the prowess of firms to respond with products. And inflation will tend to rise.

On the other side, when effective labor share is below the optimal level of capacity utilization, capacity utilization will be lower than optimal on balance and firms will have the greater prowess to pull the inflation tendency negative. The logic is that labor share is too low for an optimal economy. The lower labor share means lower liquidity prowess for consumers.

Let's look at a graph of this...

Graph #2.

The added brown line shows optimal capacity utilization, which has been rising through the years. Optimal capacity utilization is now around 88%. However, labor share has been falling. Effective labor share was above optimal in the 1970's, which gave consumers the prowess edge in the market. The 1970's was a time of inflation. But ever since the 1980's, effective labor share has been below the optimal level giving the edge to firms to control and subdue inflation. Effective labor share has fallen to around 74%.

Comparing effective labor share to the optimal level of capacity utilization allows us to identify a period when inflation tended to rise, and the current era when inflation tends to fall.

The rising of the optimum level of capacity utilization to such a high level indicates that the US economy has matured. The focus since the 1980's should have been on distributing more national income to consumers, and letting the consumers save their money for investment. Lessons to learn...

(note: Milton Friedman's complaints about the power of labor and the minimum wage came at a time when labor had more power than business. But the tables turned during the 1980's and now his complaints would not be correct.)

So far we have looked at two factors that have affected inflation over the years.

- the inflationary gaps which used to have more effect.
- the optimal level of effective labor share which shows the shift in prowess from consumers (labor) to firms.

But there is another factor, which is very important and adds more insight into the movement of inflation... The natural rate of interest.

Many economists use the real rate of interest in their models for inflation, as does David Romer. It is easier to determine the real rate instead of the natural rate. Yet, I have a way to determine the natural rate of interest from the effective demand monetary equation. (Here is a link for an explanation. Again wonkish.)

The equation for the natural rate of interest is...

Natural rate of interest = z * ((e_{a}-u_{n})^{2}+e^{2}) - (1-z) * (e_{a}-u_{n}+e) - i_{t}

z = z coefficient to position monetary framework (This shifts as effective labor share anchor shifts.)

e_{a} = Effective labor share anchor (currently 74%)

u_{n} = natural rate of unemployment (assumed to be 5% in equation)

e = effective labor share

i_{t} = inflation target in Fed monetary policy (assumed to be 2% in equation)

The natural rate of interest is very helpful to have, if you can get it. The natural rate of interest that I calculate is for the center of the business cycle. To be clearer, it is for the point in the business cycle between the recessionary gap and the inflationary gap. I could also calculate the natural rate of interest at the LRAS curve where real GDP hits the effective demand limit, but I want to focus on the inflationary and recessionary gaps in this post.

If the economy was in balance at the point between the recessionary and inflationary gaps, then the Fed funds rate would theoretically equal the natural rate of interest. During a recessionary gap, the Fed funds rate would theoretically be below the natural rate of interest in order to support the economy to recover from a recession. During an inflationary gap, the Fed funds rate would theoretically be above the natural rate to control over-heating the economy and to control inflation.

So what do we see when we compare the Fed rate to the natural rate of interest?

Graph #3.

The Fed funds rate is the green line. The natural rate of interest (center of business cycle) is the brown line. Back in the 1970's and 1980's, the Fed rate was always above the natural rate of interest, whether in an inflationary or recessionary gap. Such was the fervor to control inflation. During the 1990's, the Fed rate stayed close to the natural rate, even as it rose to battle the doube inflationary gaps in 1995 and 1997. Since the 2001 recession, the Fed rate is spending much more time below the natural rate, so is the inflation rate too.

You might notice that the natural rate mirrors the effective labor share rate. The mechanism is as labor share rises, there is more liquidity for consumption, which gives consumers a greater prowess to raise inflation. The natural rate will rise to balance that effect and show that the Fed rate should rise a bit more to control that positive inflation tendency.

I want to put all the factors above into one graph and make a few more comments...

Graph #4.

- If labor share was now at the same level it was at in the 1970's, there would be less positive inflation tendency due to a higher level of optimal level of capacity utilization.
- Inflation moved below the natural rate of interest near the end of 1997, the same time that capacity utilization fell for good below its optimal level.
- In 2006 and 2007, the Fed rate was over the natural rate during the inflationary gap, which would have been normal in years past. However, inflation had hardly moved and the Fed looks to have over-reacted. The Fed could have kept the Fed rate lower and allowed a bit more inflation. Some criticize the Fed for being too tight. It depands on how you look at it.
- Currently we are in an inflationary gap, and inflation has been going down. Labor share has fallen first, but now labor share will stay steady. Inflation will most likely stay steady and rise a bit from here. There is not much danger of deflation.
- The Fed rate will stay low near the zero lower bound, as long as the effective labor share stays so far below optimum. The inflation tendency will stay very negative for quite some time it looks like.

Graph #4 has a lot to see.

Note: You might wonder why the natural interest rate rose to almost 5% in the year 2000 when labor share liquidity was below optimal. It's because effective labor share had risen to a high level. But after the 2001 recession, the effective labor share anchor and the z coefficient shifted after being stable since 1975. The consequence of that shift was that the economy moved to a lower new normal. Interestingly enough, that kept the natural rate of interest in the 3% to 4% range. The economy is being pushed farther down with a lower labor share, and the economy will calibrate itself to a natural rate of interest in that range. I find that really interesting.