Looks like some correlation between inflation & %yoy number of employed. More workers, more new demand. (link to data)

Economy is currently at limit of unemployment where either labor share rises, capacity utilization drops or unemployment starts rising. (link)

The famous economist John Maynard Keynes tried to put forth a theory of effective demand. Keynes even devoted chapter 3 of his General Theory book to it. However, nowadays you will not see the term effective demand in economic textbooks. What happened to it? Why is the term effective demand missing from common discourse?

Keynes laid down some basic ideas about effective demand but did not give specific equations. It is clear that Keynes distinguished effective demand from aggregate demand. Still modern economists equate effective demand with aggregate demand. This is a mistake. Now we only see the term aggregate demand in textbooks.

Consequently, there is a missing piece of economic theory that is still yet to be found. How then can we understand effective demand? Will we ever have a workable model for it?

Developing a model of effective demand was my doctoral work. This is the cornerstone equation of the model.

0% < labor share – (utilization rate of capacity * utilization rate of labor)

The equation basically says that the percentage of national income going to labor (labor share) sets a limit upon the multiple of the utilization rates of capital capacity and labor. The multiple cannot be greater than labor share.

The equation shows ‘demand’ through a relative amount of money given to labor (labor share) as opposed to money given to those who own capital. Capital income at a macro level depends on selling to those who do not have capital income. Certainly many economists would say there is no difference between money spent in the economy from capital and labor incomes. However, capital production is ultimately directed towards a final consumption by people who give their labor.

The equation shows the term ‘effective’ by saying that the income share of final consumers sets a limit upon how firms utilize their capital and employment. There is an effective demand limit upon production. Capital income measures its production according to the relative strength of labor income. Thus, if people are paid less, they demand less, and firms would have to produce less for them. On the other hand, if people are paid more, they can demand more, and firms would have to increase production.

So, there is a relationship of mutual dependence between labor income and capacity utilization. The equation I use above says the dependence has a limit. So, when the limit of labor share falls, it will push down capacity utilization.

Do we see this effective demand lmit in the data? Here is data for the United States since 1969 to the 2^{nd} quarter of 2017. (quarterly data)

Yes… the limit holds in the data. The blue line sees resistance at 0% shown by the horizontal red line. (data at FRED)

When I first presented this model to economists in 2013, the blue line had not yet reached the red line. The other economists were very skeptical that the line would stop at a zero lower bound. They did not think the equation was valid. Then in 2014, the blue line bounced off the effective demand limit of labor share, as my equation predicted. Since then it has risen and is once again heading down toward the limit.

In the last two business cycles, the blue line reached the limit two times before a recession hit. Is the same pattern setting up this time?

We should know within a year, if the blue line will hit resistance again on the lower red horizontal line. If we see resistance again, the evidence for the equation gets stronger.

What would happen at the effective demand limit? Basically labor share will rise in relation to capacity utilization. If unemployment starts to rise at that time, a recession would be spreading through the economy.

The effective demand limit lines are concentrating toward a limit on real GDP of around $17.250 trillion.

Now, real GDP does not need to stop increasing at the limit, but if a recession is strong enough it will. Real GDP may continue rising, and we just see labor share rising in relation to capacity utilization.

Either way, the stock markets will react. Profits will stagante, as firms try to re-balance. When the economy is rising to the limit, profits in the macroeconomy rise and firms share in those profits. However, profits become a zero sum game at the effective demand limit. If one firm increases profits, then other firms lose an equal amount of profits. If the effect triggers problems, then the profit competition cascades into a recession.

In my calculations of utilization of labor and capital, there is a derivative of one equation that tells to what extent capacity and labor is being optimized. Here is the graph of current monthly data.

As the lines get closer to 0%, they are more optimized. When they reach 0%, they are fully optimized.

The graph shows that capacity is being fully optimized again as it was during the troubling 3rd quarter of 2104. Yet labor is being less optimized now. Capital has made improvements to their position, while labor has actually lost.

The economy expands in terms of capacity utilization until the effective demand limit is reached. The following graph shows the effective demand limit. (link to data... https://fred.stlouisfed.org/graph/?g=eUj3)

The red link of effective demand stays above real GDP.

One thing to notice about the red line of effective demand is that after is bounces off of real GDP, it rises and then levels off at some level. This is seen between 2010 and 2014. The level sets the effective demand limit for the next time that real GDP marks a process of constraining capacity utilization.

Here is another graph of my AS-ED model. Over the past 2 eyars, the down-sloping lines of effective demand are bunching together and setting up the effective demand limit between $17.1 and $17.4 trillion of real GDP.

If you can remember how the stock market hit a trouble spot back in 3rd quarter of 2014, a similar scenario is set for when real GDP reaches $17.1 and $17.4 trillion. At the current growth rate, real GDP looks to be about 2 to 3 quarters away from hitting the effective demand limit.

Experience is showing that it does not signal a recession, but a challenging period where markets need to re-order themselves.

I have not posted in a while. I am watching the craziness as Trump turns the economy against the general population.

From what I see, inequality will grow... and importantly, negative externalities will grow and accumulate. Businesses will make more profit in the short-term, but in the medium-term, the negative externalities will burden the economy.

I still expect a recession this year in 2017.

Here is a graph that shows the fall of core PCE inflation from its peak in 1981 to the present. (link to quarterly data)

Inflation has fallen with stable swoop downwards. We are currently at about the 0.1 mark on the x-axis showing a core PCE of 1.6% on the y-axis.

The graph implies that inflation is a long way from returning back to the conditions when inflation was high. So the x-axis must tell a story of inflation. What is on the x-axis? Let's look at its equation...

Profit per unit of real gross value added of nonfinancial corporate business: Corporate profits after tax with IVA and CCAdj (unit profits from current production) - (60%*Fed rate +40%*10-year treasury rate)

The equation basically takes the real after-tax profit rate and subtracts a measure of the nominal rate which blends short-term rates with long-term rates.

When nominal rates are high, we would expect inflation to be high too. Why? Well, when inflation goes high, nominal rates go high to control inflation. But there is more to the story. Nominal rates can float inflation upwards, or knock it down depending on how strong nominal rates rise.

Here is the model for the graph. The upsloping red diagonal line is the real cost boundary. Corporations want to be to the right of this red line. Then their after-tax profits are positive and the economy can grow or stabilize. But to the left of this red line, corporations are forced to contract from negative after-tax profit rates.

Net Profit rate = real profit rate - nominal rate + inflation

If corporations can keep prices rising ahead of nominal rates, then they can deal with profit rates being squeezed. But if the central bank does not like rising inflation, nominal rates will get aggressive and can force net profit rates negative. This happened in the Volcker recession. As soon as Volcker jacked up the Fed rate, the data points were pushed to the right of the red diagonal line and the recession ensued, which brought down inflation.

In the model above, the black arrow shows that inflation rises when nominal rates are rising but not strongly enough and inflation can keep ahead of it. Then when nominal rates get aggressive, we follow the dashed red arrow to the left side of the real cost boundary. Then we follow the green arrow down, where inflation is dropping and nominal rates can follow them down.

I view the dynamics like inflation is a mouse and nominal rates are a cat. If the mouse can stay ahead of the cat, the mouse will keep moving in the same direction. If the cat can get ahead of the mouse, the mouse will turn around and head back in other direction.

Currently we are far from the red diagonal line. Real profit rates are at historic highs and nominal rates are low. Yet, people think that inflation will shoot up soon because nominal rates are going up and profit rates are coming down. So corporations will have to react with price increases.

However, real after-tax profit rates will have to come down much farther, and nominal rates will have to rise much further. My view is that real after-tax profit rates may actually rise if corporate taxes are slashed last year. As well, the Fed will most likely raise the Fed rate slowly as Stan Fischer has stated.

Since the model above sees very low inflation pressures for years, the Fed will be justified in raising the Fed rate slowly. Ultimately, bond yields will come back down from the recent increases.

Last week the markets moved. Bonds yields went up. Stocks went up. Inflation expectations were awakened.

What will the Fed funds rate do? How might the Fed respond?

I will do an analysis to project a path for the Fed Funds rate based on my research into effective demand. (a synopsis of the research.)

Effective demand is basically a limit upon the utilization of capacity determined by labor share. As labor share falls, the optimal utilization level of capacity also falls. We have seen labor share fall. At the same time capacity utilization trended lower. My research into effective demand is built upon the following graph.

The original description that Keynes and others gave for effective demand pointed to profits as the driving factor. Once entrepreneurs see profit rates peaking, they will stop utilizing labor and capital because if they did, profit rates would decline.

My models of effective demand track the profit rate cycle. (link)

The profit rate cycle tracks the business cycle. The following graph gives a profit rate based on profits in relation to GDP. (link to FRED data)

The profit rate rises and then falls in each business cycle between recessions. It would appear that this business cycle is nearing its end.

As I started this post, I mentioned the moves in markets during the last week. There is revived hope of getting the economy going again. Trump promises fiscal expansion, deregulation and lower taxes. In short, there's seems to be a business expansion being revived using supply-side strategies.

It is not common in the profit rate cycle (graph above) for profit rates to climb back up to two major peaks before a recession. But let's assume that this business cycle can be revived without a recession taking place. What might that look like?

In the model of effective demand, capacity utilization is optimized at the effective demand limit. Profits from the utilization of capital are maximized. Entrepreneurs see that profits cannot be extended, so utilization of their capital is held back.

But what about the utilization of labor? Labor is used only in order to optimize capital. The priority is to maximize capital. That is how profits are maximized. Labor actually eats into profits. So there is a dance between labor and capital, where capital is actually leading where labor goes.

The following graph tracks the path of utilizing labor and capital. Once the path hits the effective demand limit, capacity utilization will either stop rising or fall. It fell in this business cycle. I predicted this in 2013 before it happened in 2014.

So now I look at this graph and ask... Where can this path go now assuming that the business cycle is being revived?

One thing is for sure, the unemployment rate cannot rise. That would trigger a recession and end the business cycle. So unemployment either has to stay around 5% or go lower. Then capacity utilization would have to start rising. I will assume that unemployment can go down to 4.5% while capacity utilization goes up to 78%. That would take the path back to the effective demand limit with increased utilization of labor and capital.

I have been lightly touching upon the forces that shape the business cycle so far. Mainly there is a profit rate cycle based on optimizing capital which is impacted by labor share as an effective demand limit.

The Federal Reserve would like to have monetary policy guide the business cycle into full-employment while stabilizing inflation around a target.

My research has a model for describing the best Fed rate path based on the effective demand limit and the accompanying profit rate cycle. (link) Basically the Fed rate needs to be normalized at the effective demand limit. Normalized means that the Fed rate equals the inflation target plus the natural real rate of growth in the economy. Currently the inflation target is 2% and the natural real rate is estimated around 2%.

Here is my estimation of the natural real rate which is based on my estimation of potential GDP.

The natural real rate changes as economic conditions change. The natural real rate normally peaks around the peak of the profit rate cycle. I will assume that the revival of the business cycle taking place at the moment raises it to 2.5% which is still below the previous peak and honors the business expansion expectations currently taking place.

So now I plug into the model the numbers needed. Optimized capacity utilization = 78%. Unemployment = 4.5%. Natural real rate = 2.5%.

The model kicks out an equilibrium inflation target which the economy would find easier to maintain. In the past recent years, the model kicked out an equilibrium inflation target below 2%. But now it kicks out an equilibrium inflation target of 2.3%. This means that inflation potential is rising with the selected parameters.

Here is what the model forecasts.

Let's start the analysis with the vertical green line which is the effective demand limit. It sits at 78% of capacity utilization. That is where capital will be optimized. Next, the normalized Fed rate would be 4.8% based on a natural real rate of 2.5% plus an equilibrium inflation potential of 2.3%. (Inflation potential is rising with the projected plans for fiscal policy. The Fed would have to push the Fed rate a bit higher to control inflation.)

Next, the solid orange line shows the path of the Fed rate to normalization (red dot) when capital is optimized. It currently sits near the zero lower bound with a capacity utilization near 75%. The path upward is measured by increases in capacity utilization.

The solid yellow line shows a projected path for inflation potential. The model shows that core inflation could reach 3.2% at normalization. Inflation potential would increase. So the Fed might have to raise the Fed rate a bit faster to control inflation.

The path is steep upward depending on how fast capacity utilization can rise. Stan Fischer of the Federal Reserve says rates need to go up gradually. So if capacity utilization goes up gradually, everything should be alright. However, there is a possibility that the Fed rate will need to go up faster than some at the Fed are prepared for depending on if the fiscal stimulus is aggressive.

If the Fed rate rises too gradually in relation to capacity utilization, one might expect a bubble to form somewhere or inflation to push upward faster than wanted.

Now it may seem pretty crazy for a model to project such a steep path upward. Yet, the IS-LM model gives a similar view of how this happens. At the end of a business cycle, the LM curve can be steep or vertical.

The figure shows that as the IS curve shifts rightward due to strong fiscal stimulus, interest rates rise (r_{1} to r_{2}), but output really does not. My model has a method to optimize the x-axis with effective demand to show where the "LM" curve goes vertical.

I see trouble ahead. There are forces ready to push inflation and interest rates up, but the effect upon real GDP will be disappointing.

Economists do not have a measure of an effective demand limit. My research is unique. So they would not expect the renewed expansion to end so abruptly. That will create confusion. I foresee frustration between the government and the Federal Reserve.

The problem rests in that the business cycle is already in its dynamics of ending. The Fed rate has gone way behind the curve letting the business cycle develop more zombie soft spots than normal. Zombie soft spots drag down net economic benefits to society. So the economy is sensitive to the discipline of higher interest rates in a negative way.

This graph shows yoy %change for the U-3 and U-6 rates for unemployment. (link)

They are on a normal trend of a business cycle where they bottom out and then head upwards. When the trend starts to go positive, a recession is imminent. The trend is just now hitting 0% which in the last two business cycles signaled a recession about 3 to 9 months ahead of time.