I will present a way to determine potential real GDP using a regression of past data. First take the official CBO potential and subtract it from real GDP.
When the red line is above zero (0), real GDP is over potential. Normally the red line rises above potential before a recession. So it looks as though we are from a recession at the moment.
Now I will do a regression with this line against 3 variables.
Capacity Utilization (TCU)
Unemployment rate (UNRATE)
Labor share index, non-farm business (LSI)
Generally in the regression, capacity utilization and unemployment will represent real GDP. Labor share will represent changes in potential.
But I will select parts of the line above for the regression. Yes, I am cherry-picking because I do not trust the CBO potential of the 1990's. The CBO had a terrible time ascertaining potential in the 90's with new technologies and such. The CBO is still having a terrible time as they constantly adjust potential.
The time periods for the regression are
1967 to 2nd quarter 1990
1st quarter 2004 to 2nd quarter 2007
I take out the 1990's and the data since the crisis because there are more doubts about their validity.
Here is the report of the regression.
Adjusted R Square
The adjusted R square is 90%. The P-values are low.
What does this regression look like plotted against the official line above?
The new plot (green line) is a way to assess real GDP in relation to potential. The line tracks well with official numbers before 1990 and before the crisis.
But how does the regression fill in the time periods left out of the regression? It shows that real GDP was over potential in the 1990's in a moderate way as compared to the steep rise to a very high spike seen in official data. The line implies that in the 90's, real GDP went over potential about to the same extent as before the 1980 and 1991 recessions. (Maybe the Fed did not have to raise the Fed rate as much as they did near the turn of the century.)
The regression implies that real GDP was sitting at potential for a few years before the crisis.
These differences from the official line (red) are somewhat reasonable.
Yet, now the regression is implying that real GDP reached potential during 2014. This may also be reasonable because one might expect unemployment to drop quicker than expected when real GDP reaches potential.
Note: One might assume that labor share is fairly constant and that the real driving forces behind the regression are capacity utilization and unemployment. However, labor share itself was changing in response to these cycles of real GDP around potential.
When labor share drops, the regression says that potential drops. And when labor share rises, the regression says that potential is rising. When labor share drops, real GDP seems to move faster toward potential, because according to the regression potential is dropping toward real GDP.
Is real GDP at potential?
Will real GDP rise much more?
or Will the utilization of labor and capital stabilize now if real GDP is at potential?
Will the decline in capacity utilization during March stick around?
Even if labor share was to rise now, would real GDP still seem to stabilize around potential according to the regression? So that a rise in labor share is matched by changes in the utilization of labor and capital to keep real GDP near potential?
In the last post, I did a regression for real GDP in relation to potential GDP. The adjusted R squared was 85% and the graph looked like this. (Orange line is official CBO real GDP - potential real GDP. Blue line was my regression based on capacity utilization, labor share index and monetary policy.)
Now I change the regression by taking out my measure of monetary policy and replacing it with the unemployment rate. Here is the report of the regression.
Adjusted R Square
The adjusted R squared has risen to 90%. The equation for the regression is...
Real GDP - potential real GDP = 23.37*capacity utilization - 8.12*Labor share index - 41.84*unemployment rate - 829.32
The graph looks like this... (I have highlighted the times periods that were used to make the regression.
This blue line is a better fit. It shows more stability in the late 1990's with real GDP consistently a bit over potential. Real GDP was a bit over potential before the crisis. And now it shows that real GDP hit potential in 2014 with the quick drop in unemployment.
This new regression would explain why the US economy has been doing well over the past year, since real GDP has reached potential. The regression also implies that there is not much slack remaining.
I want to take a new look at potential real GDP. I start with the graph of real GDP - potential real GDP according to official data.
In the past we see that real GDP would rise above potential at various times and then fall below potential during downturns. Do you really believe that real GDP was way above potential in 2000? I do not. Potential was higher than the CBO said.
Currently the data says that real GDP is $300 billion below potential. Ultimately the question is ... Is real GDP really $300 billion below potential? I do not think so. That is what I want to explore with some regressions.
I have written about this before. Here is the graph from before.
This old graph fro March 2013 shows just how much the CBO has adjusted the potential. The line was almost flat from its bottom back then. Now real GDP is shown to be rising much faster toward potential because potential has been repeatedly revised downward.
Anyway, my line (pink) was simply comparing effective labor share and capacity utilization. My line got very close for much of the past data. But now I want to use some regressions.
I take the official difference between real GDP and potential real GDP and regress it against 3 variables over time.
Labor share index (LSI)
Capacity utilization (TCU)
Total monetary effect from the effective demand limit equation. (This variable assesses the looseness of monetary policy by comparing the effective demand Fed rate, Effective Fed funds rate and the 10-year treasury rate.) (Tot monet)
I first regress against all past data since 1967 for these variables.
Adjusted R Square
P-values are all very low. Adjusted R squared shows that 70% of data is described by the variables. Here is the graph for plotting the equation of the regression.
This regression result agrees that currently real GDP is well below potential. But the regression implies that real GDP never got close to potential before the crisis. This does not hold up under scrutiny.
The main problem with this regression is that it includes the data for potential real GDP in the 1990's which adjusted too much downward in 1991 in my opinion. Then potential did not adjust enough upward after 1998.
So now I select out the years from mid-1990 to 2003 and the years since mid-2007. Then the regression results look like this.
Adjusted R Square
P-values are all low. Adjusted R squared has now risen to 85% from 70%. Here is the graph plotting the regression.
This graph makes much more sense. It says that real GDP was very near potential before the crisis for a number of years. The lines match up very well before the 1990's. It also says that real GDP settled back down to potential before the 2001 recession.
The regression is not perfect yet shows a better probability that real GDP has been near potential since around the beginning of 2014.
One thing I see in the last graph is that recessions occurred when real GDP was at potential even after having been above potential. This seems strange since real GDP at potential should be a steady state and ideally stable. It may be that the dynamism of capitalism cannot tolerate a steady state.
Paul Krugman writes about GE's announcement to get out of the finance business. Why are they getting out? Financial reform from the Dodd-Frank legislation that includes "greater oversight, higher capital and liquidity requirements, etc."
Paul Krugman says...
"And sure enough, what GE is in effect saying is that if we have to compete on a level playing field, if we can’t play the moral hazard game, it’s not worth being in this business. That’s a clear demonstration that reform is having a real effect."
Standards are tightening in the financial business to prevent moral hazard. Higher liquidity and capital requirements will go hand-in-hand with the Fed's intent to raise interest rates. So I see a positive side to normalizing interest rates in that some socially risky shadow banks will opt out.
Less shadow banks could translate into an easier time for normalizing the Fed rate. We wouldn't have these shadow banks doing arbitrage and such with their moral hazard to put downward pressure on interest rates.
What do you think? Does financial reform make normalizing interest rates easier? Does the lack of financial reform cause the Fed rate to seem stuck at the zero lower bound? Can the Fed rate rise without good financial reform? How important is financial reform to the normalizing of the Fed rate?
I read Paul Krugman, Ben Bernanke and others. They mention two reasons why some people are calling for interest rates to rise...
Possibility of Inflation
Possibility of Financial instability
Now I would like interest rates to rise, but I have never seen any inflation coming. In fact, it seems that inflation will stay low when interest rates stay low in our present economic conditions. I have written about that before in relation to the Fisher effect here on Angry Bear.
As far as financial instability, my concern is more inequality which is subduing effective demand.
But there is a third reason that these economists don't ever seem to mention... The economic inefficiency of low interest rates.
Look at China. They have over-invested clearly. They have over-capacity in production. Their financial repression with low interest rates has led to over-investment. What do they do now? They roll over debts, keep interest rates low and try to keep these unnecessary firms active. In the US, firms still have debt. They pay interest costs. These low-productivity firms would most likely cut back production, hiring and may even go out of business if interest rates rise. So in order to keep these weak firms active, interest rates must stay low.
Low interest rates make the existence of these marginally weak firms much more possible. Of course, we do not want run-away inflation, nor even financial instability. However do we want these debtor weak firms which weaken the economy?
If we do not want them, we have some options.
We can write off debts, which could include mortgage debts of households.
We can raise taxes on corporations and the rich.
We can close loopholes that allow profits to be hidden overseas.
We can raise interest rates.
A combination of all four options would eventually strengthen our economy.
Imagine a football team that has some weak players. The team is not replacing these weak players. The team is mediocre from year to year. Then the team starts setting higher standards for its players. It starts cutting weaker players and investing in better players to meet that higher standard. The result will be a better team with better profit potential because they will win more.
If the economy started weeding out weak firms with higher interest rates, they would be replaced with newer-technology firms without old debts from before the crisis. Do you see where I am going with this? Eventually the firms within our economy improve on average. Productivity will increase. Wages have a better chance to rise... and so on.
So arguing that interest rates should stay low because inflation is not likely and bubbles of financial instability should not be popped misses another reason to raise interest rates... to maintain the standard of excellence in the economy in line with medium-run potential. That means raising the Fed rate along an appropriate path so that the short-term real rate rises toward its medium-run natural real rate. Then it is just a matter of how much slack you see for setting that path.
Janet Yellen and the Fed seem to be focused on the slack more than anything. They feel the time is coming to start raising the Fed rate. They recognize that economic growth will slow down some as marginal businesses are tested with a higher interest-rate standard. They may even feel that is a good thing.
There is discourse in the econoblogosphere currently about why interest rates are low and may stay low for a long time. Larry Summers says that we may even have a negative natural real rate at full employment, even though Ben Bernanke sees that as somewhat impossible.
It is fairly common knowledge that excess debt and leveraging built up before the crisis. That is economic inefficiency. So we now have a situation where debt is actually growing again internationally. China has accumulated economic inefficiencies in its surge of investment. The effect is to subdue borrowing for global investment which leads to lower interest rates internationally.
So how do we cure the past economic inefficiencies that seem to still be with us? Do we keep interest rates low so that firms and people with debt on the margin won't go bankrupt? Or do we raise interest rates to start cleaning them out?
If we keep interest rates low, marginal debt will continue and the global economy will LIMP along for who knows how long. And would the economic inefficiencies indirectly fade away through renewed growth as we approach full employment? Maybe, maybe not. Mark Thoma has said, and I agree, that wages will not rise due to globalization, technology and slack/weakness in the labor's power to ask for higher wages... even at full employment. Thus, inflation would stay low even at full employment. As well, aggregate demand will stay low from weak wage growth.
If we raise interest rates in the US, the economy will slow down some as Janet Yellen has said. A rise in interest rates will hinder firms and people on the margin. Some of them may even go bankrupt. Also, the dollar will rise stressing marginal foreign firms that have borrowed in US dollars. Economic inefficiencies will be directly forced out through higher interest rates.
There exist economic inefficiencies that weaken the global economy. We can get rid of them in an indirect way that may not work even at US full employment or a direct way with some discomfort.
I have been upset with Paul Krugman for years since he undermined the living wage movement in the 1990's. Here is what he wrote back then...
"In short, what the living wage is really about is not living standards, or even economics, but morality. Its advocates are basically opposed to the idea that wages are a market price--determined by supply and demand, the same as the price of apples or coal." (source)
He is saying that the labor market is the same as the market for products and commodities. Now we read today...
"Even more important is the fact that the market for labor isn’t like the markets for soybeans or pork bellies. Workers are people; relations between employers and employees are more complicated than simple supply and demand." (source)
Paul Krugman is coming of age in his view of labor's wages...
I overlaid my real time real interest rates on top of his graph.
My real interest rate calculation is real time in the business cycle. So in 2009, my real interest rate shows that the economy needed a very low real interest rate to spur it on. Whereas his real interest rate was looking forward as an average over 5 years. You can see that the 5-year real interest rate gradually declined after 2009 to 2013, while my real time real rate was climbing with the recovery.
In 2013, I notice the disconnect between the two. My real rate was saying that the economy was getting ready for liftoff, while markets were projecting low growth. Then in mid-2013, the markets realized this disconnect and the real rate started to climb toward my real time rate which was projecting strength in the business cycle.
Since 2013, the markets are projecting a pessimistic next 5 years in relation to where the business cycle is now. My real time real rate is higher than what the markets see over the next 5 years. So the markets are projecting a downturn within 5 years.
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: