Monetary policy seeks to obtain price stability. In this endeavour, the Federal Reserve sets an inflation target, which allows them to set a Fed rate. If inflation goes over the target, the Federal Reserve will raise the Fed rate to bring inflation back down by reducing the amount of money flowing into the economy through the financial sector. If inflation is below the target, the Federal Reserve will lower the Fed rate to encourage more money to flow into the economy through the financial sector.
I am going to evaluate the tightness and looseness of monetary policy since 1967 using an equation from the effective demand research. The equation prescribes a Fed rate based on utilization rates of labor and capital (the factors of production), labor share (a measure of consumption liquidity) and an inflation target.
Fed rate according to Effective demand, F = z * (T2+L2) - (1-z)*(T+L) - i
F = prescribed Fed rate
z = coefficient of for the equilibrium state of the economy
T = TFUR, total factor utilization rate, (capital utilization rate * labor utilization rate)
L = Effective labor share, measure of labor share that determines effective demand limit
i = inflation target
This equation does not depend on the Potential real GDP as the Taylor rule does. The problem with potential real GDP is that it does not take into consideration the effective demand limit which could be lower, as it currently is. My equation bypasses that error in the Taylor rule and goes directly to factor utilization rates and labor's relative liquidity for supporting consumption and by association, production.
I will take this equation to evaluate the Fed rate since 1967. To do that, I substitute in the actual Fed rate since 1967 for the term F in the equation. Then I solve for the inflation target.
i = z * (T2+L2) - (1-z)*(T+L) - Fa
Fa = Actual Fed rate, not prescribed Fed rate.
This equation will give the implied inflation target by the Fed rate that is designed to balance inflation back to target. If inflation is far above the target, then the implied inflation target has to be way below the target to bring inflation back to target. Here is a graph of the actual inflation rate and the implied inflation target as given by the equation (since 1967, quarterly data).
Graph #1
When the implied inflation target is below actual inflation, the Federal Reserve is trying to lower inflation down to target. As well, when the implied inflation target is above actual inflation, the Federal Reserve is trying to raise the inflation rate to target.
There is a point halfway in between these two measures that is the implied inflation goal, which represents where the Federal Reserve is trying to move inflation. This point is simply the average of the two lines.
I now add the implied inflation goal line to the graph #1.
Graph #2
The implied inflation goal (red line) shows where the Federal reserve would like inflation to be. We can see that back in the 60's and 70's, the Federal Reserve preferred an inflation target around 3%. During the 90's up until the crisis, the Fed preferred an inflation target around 2%. (see yellow line) Since the crisis, the Fed has been trying to push inflation to between 3% and 4%. But inflation is not budging due to low labor liquidity for consumption, which itself is due to labor share declining 5% since the crisis.
How can we use the above graph to evaluate the looseness or tightness of the Fed rate? Whenever the red line is above the yellow line, the Fed rate is loose. The implication is that the Fed rate is moving inflation to a goal above the inflation target.
From what I see in graph #2, the Fed rate was neither very loose nor very tight during the 60's and 70's. However, the Fed rate was very tight during the 80's, when the implied goal according to the actual Fed rate was around 0%. Since the 80's, the Fed rate has been pretty spot on matching the implied policy goal with an inflation target of 2%. The Fed rate was loose from 2002 to 2005, then again during 2008.
Since 2011, the Fed rate can be considered very loose by historical standards. The implied Fed rate to balance low inflation is around 7%. But inflation is not budging due to the dynamics of weak labor liquidity for consumption that has been developing since the 90's.
If the Fed rate could go lower than the zero lower bound (ZLB), the implied inflation target would go even higher and the implied inflation goal would go even higher too. My analysis states that even though the Fed rate is up against the ZLB, the Fed rate is still loose considering utilization of labor and capital and labor's liquidity share of national income.
As I have shown before, the Fed rate is drowning due to low labor share. The Federal Reserve will have to learn that it must raise the Fed rate in spite of high unemployment because the depth of the water that it is in has changed due to low labor share. There isn't enough labor liquidity to support the old standards for the Fed rate.
All in all, the Fed has done a remarkable job in keeping the Fed rate in line with an inflation target over the years.
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