Capacity utilization dropped in November. The drop takes me back to when I first began formulating the equations for effective demand in 2012. I made predictions to test the equations. Each prediction guided me to understand effective demand. One early prediction was that the natural rate of unemployment was around 7%.

This graph comes from a post in May, 2013. The linear trend line for the red dots was heading toward a y-intercept of 7.25, where UT goes to 0%. UT at 0% represents 0% spare capacity or full-employment of labor and capital.

The problem was using a linear trend line for only a portion of the data points. The trend line should have been a polynomial using both the red and yellow dots. It would have given a y-intercept of around 6%.

The latest version of the graph looks like this...

The y-intercept is trending to 4.9%. The other equation shows a natural unemployment rate of 5.1% for data before 2009.

But the unemployment rate ended up falling well below that "better" natural rate of 6%. How did I explain that? The Cobra equation.

I found the Cobra equation back in October, 2013, to show how unemployment and capacity utilization move together along the effective demand limit. The equation gives a path of increasing profits alongside the effective demand limit.

The Cobra equation implied that as unemployment falls at the effective demand limit, capacity utilization will fall also instead of rise... giving more room for unemployment to fall further. Business cycles had followed this equation before... Would this business cycle follow it?

I was not sure at that point how low unemployment would really go. I wrote back in October, 2013...

"I was projecting a lower limit of 7% for unemployment, but that was based on capital utilization rising. Now I have to reconfigure how low unemployment might go." link

So did capacity utilization and unemployment end up following the Cobra equation? Yes, near the end of 2014, they started following the Cobra's profit-max limit. Here is the latest graph using monthly data that includes the data for capacity utilization that came out today.

Conclusion

Just as the Cobra equation predicted, aggregate capacity utilization dropped so that unemployment could fall further along the profit max limit... and it fell nicely parallel to the limit.

Finding the Cobra equation in 2013 before the economy followed it again in this weird business cycle gives me comfort. The original prediction of a natural unemployment rate was re-worked to give a better model of unemployment at full-employment along the effective demand limit.

Edward,

Thank you for revisiting the COBRA equation...How do you assess likelihood that lower Cap Util AND lower unemployment lies ahead? Versus move towards full contraction environment?

Enjoy having you back in the blogosphere for this critical time!

Alan

Posted by: Alan T | 12/16/2015 at 10:03 AM

Alan,

The pattern is looking like we are very near an economic contraction. But the contraction is hiding from plain sight. My sense is that something will trigger weaknesses in the markets exposing them. My sense is that will happen within 6 months, but labor share is rising, which could trigger a contraction or extend the biz cycle. But I do not see a bubble, so a contraction is more likely.

Posted by: Edward Lambert | 12/16/2015 at 10:14 AM

Thank you. Yield curve over next couple of weeks could be quite telling. Flattening already shows from last month or so. Could get more demonstrative once lift-off occurs.

Posted by: Alan T | 12/16/2015 at 10:44 AM