When the Fed rate is far from the natural rate of interest

What about when Fed rate is far above or below the natural rate of interest?

Steve Roth of angrybearblog asked about the Fed rate being so high from the late 70's to 1987. Was the Fed rate too high? Should it have been lower according to the model in this graph?

Graph #1

Why was the natural rate of interest so much lower than the Fed rate during Volcker's recession?

The economy was transitioning from a period of excess labor share to one of balance between labor and capital. Labor's power was waning, but wages were causing inflation through wage contracts. The effect was aggravated by the oil shock. The inflation was unnatural.

Let's read the definition of the natural rate of interest again... Federal Reserve paper written by John Williams in 2003.

"In this Letter, the natural rate is defined to be the real fed funds rate consistent with real GDP equaling its potential level (potential GDP) in the absence of transitory shocks to demand. Potential GDP, in turn, is defined to be the level of output consistent with stable price inflation, absent transitory shocks to supply."

The definition of natural rate of interest depends on the lack of shocks to demand and supply. Well, around 1980, there were shocks to both supply and demand causing a spiraling of inflation. Volcker had to use unnaturally high rates to stabilize the economy due to these shocks.

My general view is that high rates stabilize the economy. Stabilization is good when labor or capital is over-inflating. Low rates destabilize the economy. Destabilization allows labor or capital to more easily inflate when there is a recession.
Volcker had to stabilize the effect of wage inflation and oil prices. I agree with Volcker in raising rates, but he did it in an excessive way. He should have returned to a normal Fed rate during 1984, when effective demand stopped declining. Here is a graph with effective demand over time.

Graph #2

Effective demand (white line) stopped declining in 1984. Volcker raised the Fed rate when he could have just kept it steady. Effective demand started to rise in 1984 because capacity utilization started declining and labor share started rising. Unemployment which had been falling stabilized. Inflation was ticking upward, but unit labor costs were ticking downward. So in my opinion, he did not have to worry about the inflation as much as he did. If he had let the Fed rate keep ticking downward, unemployment could have kept declining and capacity utilization may not have declined so much. In effect, he created another downturn just because inflation was ticking up. But the inflation was only going to be temporary because unit labor costs were not following inflation.

(note: In graph #2, you will see that effective demand levels out many times, then the economy grows to it. Especially notice that effective demand was level from 2002 to 2008. And it is now level again. A recession will occur when real GDP reaches the point where effective demand first leveled off. It takes 2 to 6 years. However, you will see that pattern throughout the graph above. The implication is that the next recession will happen when real GDP reaches somewhere around $14.1 trillion.)

So is the current low Fed rate appropriate?

So is the current low rate appropriate for the demand shock of 2008? In my view, the zero lower bound (ZLB) interest rate was appropriate until 2ndQ-2011, when effective demand stabilized and leveled out. We can see in graph #2 that effective demand (white line) began to level out in the middle of 2011. It is at that point that the Fed rate should have returned to a normal relationship with the natural rate of interest. In other words, the Fed rate should have started rising in the 2nd half of 2011.

Instead, low Fed rates have become ineffective and overly destabilizing since then. Effective demand was not going to budge from that level path, unless labor share rose. Labor share was not going to rise naturally in a low employment environment.

Graph #3

We can see in this graph that effective demand leveled out at the last red dot, which corresponds to 4thQ-2010. Effective demand more solidly settled into this path in 3rdQ-2011. The demand shock, or better put the "effective demand" shock, was over at that point, and the Fed rate should have returned to a normal relationship with the natural rate of interest. The path of the effective demand since 2010 has been heading steadily toward the neighborhood of $14.1 trillion.

The ECB actually did raise their base rate in 2011, but backed off with huge pressure from the US Treasury and the Federal Reserve. Some Fed officials are now saying that continued low rates will destabilize markets. Yes, they will.... but the writing is already on the wall... The recession is predicted when real GDP is around $14.1 trillion.