Inflation is low, 1.6% or lower. There is worry that it is too low, because it is below the Federal reserve target of 2.0%. How can we raise inflation?
First, let's look at a dynamic of why inflation is low...
Over the past 6 quarters, inflation has been trending lower, but as you can see, effective demand is trending lower due to a normal increased utilization of labor and capital. As the price level of effective demand decreases, this puts downward pressure on inflation. People are willing to buy output at lower and lower price levels. Inflation is in effect being suffocated. The Fed rate has no traction to help inflation.
With the Fed rate already pushing on 0%, the issue is to try to get the Fed rate back into positive territory. This requires a rise in inflation or a rise in the labor share of income.
Inflation cannot rise because it is being pushed down by declining effective demand. So what if we raise labor share of income?...
In this graph, I have taken 1Q-2013 data and simply made one change. I have changed effective labor share from 74% to 76%. The yellow lines show 74%. The blue lines show 76%.
The effective demand curve shifts right, as is to be expected from a rise in labor income & consumption. However, the aggregate supply curve has shifted left because of increased unit labor costs. It is true that an increase of effective labor share from 74% to 76% increases effective unit labor costs from 96.4% to 99%.
Potential real GDP stays constant at $13.575 trillion. LRAS curve stays constant at around $13.810 trillion. Now, it is important for us to notice that the price level of effective demand has gone higher to around 8.0%. We are relieving the progressive pressure pushing down on inflation. But there is even a more important result...
By raising effective demand overall, we are raising the price level at which the economy is willing to demand the same amount of output. This is key to raising inflation. When the economy returns to $13.750 trillion real output, the price level of effective demand would be over 7% instead of the current 4%. This means people would be willing to accept a higher inflation rate due to increased labor share of income.
When we use the ED rule for the Fed rate given above for an effective labor share of 74%, the Fed rate is -0.77%. When we raise the effective share to 76%, real output declines, but then it starts to rise again from increased effective demand. Inflation will tend to increase. If we say that real output rises back to the current $13.750 and inflation rises from 1.6% to 2.5%, the calculated Fed rate would rise to +0.19%. The Fed rate would be back in positive territory, where it can gain traction in the economy.
So raising labor share of income is a solution... But...
But there is one problem, a big problem. When unit labor costs rise, an economic contraction can be triggered. The probability of a contraction is greater when effective demand is low like now. Aggregate profit rates are already stagnating. A rise in labor share of income now, would probably trigger an economic recession, instead of just a temporary contraction followed by a more robust economy. The economy is more sensitive to rising unit labor costs now.
Labor share of income should have increased a year or two ago. At that point, the economy had momentum from rising profit rates. It would have recovered from a hit to real output. We would be in a much better position now for higher inflation, and more importantly, a positive Fed funds rate with traction to maneuver the economy.
The bottom line is that if labor share was to be raised now, it would have to be done much more slowly.. much more carefully. And a slower pace would probably not be enough to save inflation nor the Fed funds rate. The end of the current expansion is in sight... We just wait for the UT index to go below 1%.
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