Update on Monetary Policy of Effective Demand

I posted a model for a monetary policy in regards to the Fed rate months ago. I now update some views on that model.

Here is the updated model with data from 3rdQ-2013.

The red dot shows that a Fed rate of 2.4% is prescribed by the model. How is this determined?

The vertical green line marks the LRAS curve, or the natural level of output. At the LRAS curve, the utilization of labor and capital is capped. Further increases in production or demand would result in inflation.

The downward sloping green line measures the spare capacity in the economy. Currently the spare capacity is running low, about 1% growth left. Many economists think there is still a lot of spare capacity left in the economy, but they do not follow the principles of effective demand like I do.

Since there is little capacity, there needs to be a Fed rate above the zero lower bound (ZLB) in order to balance the risks in the financial market. Hitting the LRAS curve with a 0% Fed rate could be dangerous leading to high instability in the financial markets.

The horizontal blue line shows the current inflation running around 1.7%. There is a possible risk of inflation as the red dot nears the LRAS curve, so a Fed rate above inflation would be a safe measure.

The up-sloping violet line is the Fed rate path prescribed by a z coefficient of 59.73%, an inflation target of 2%, and an effective labor share anchor of 72.7%. The equation of the Fed rate path is...

Path of Fed rate = z*(TFUR² + els_a²) - (1-z)*(TFUR + els_a) - inflation target

The effective labor share anchor is observed over the business cycle by using the reflective Fed rate equation...

Reflective Fed rate curve = els*(els - TFUR)/(1 + TFUR)

els_a = effective labor share anchor... els = actual effective labor share... TFUR = labor utilization x capital utilization

Here is a graph with data up to 3rd quarter 2013. The recent data (dark blue line) shows the effective labor share coming to settle at 72.7%. Green line is data from 1975 to 2009. We have seen effective labor share slowly and surely come down to this point over the past few years. It now sits at 73.1% and has just a little more to go in order to reach its anchor at the LRAS curve. Note: We would have known a few years ago that labor share was trending to this 72.7%. Interesting thought yes?

The reflective Fed rate equation foretells what the effective labor share rate will be when the economy hits the LRAS curve... irregardless of what the effective labor share rate is. For example, back in 2nd quarter of 2010, the effective labor share was 74.8% and the TFUR was 66.5%. According to the equation, the corresponding interest rate was 3.7%, which is a measure of how far the economy is away from the LRAS curve. If one were to draw a line from 3rd Q 2009 to 2nd Q 2010, it would have foretold an effective labor share in the low 70%s. This observation would have been very helpful back in 2010. The above graph shows how reliable this equation has been for decades.

The z coefficient is based on the effective labor share anchor of 72.7% and an effective range for the TFUR of only 6%. Why such a low width for that range? First, the economy requires low rates to recover from the crisis when the TFUR is low.  Second, the Fed rate has to be adjusted lower since labor's liquidity is so weak. Third, inflation needs a chance to rise in the face of weak labor liquidity. Fourth, there still needs to be a positive Fed rate to protect against the risks of financial instability around the LRAS curve.

In the first graph, you can see two alternate routes of the Fed rate to the LRAS curve. The Fed rate could take the higher path (violet line) or take the lower path (yellow line). The higher path would be used in times of a normal business cycle. The lower path along the effective demand limit would be used as a stop gap to protect the economy against financial instability and a sudden collision with the LRAS curve. The Fed did not take either of those two paths and has maintained the Fed rate at the ZLB thinking there is still a great deal of capacity in the economy.

We now see the Fed is stuck in QE and can't get out. The growing instability in the financial markets is now being covered over by continued QE. If the Fed even hints at cutting back its QE program, the markets overreact. The Fed should have been more proactive against this, when there was more room to the LRAS curve. According to this model, the Fed rate should have started upward at least by the end of 2011 when the TFUR was 70% and there was functional traction available for the Fed rate. It is now 72% and close to the LRAS curve at 72.7%.

Larry Summers has called for a change in the monetary framework that would "make bubble-free growth possible". This model works toward those ends.

We need a Fed rate with traction. This model prescribes a Fed rate between 2% and 3% when the economy hits the LRAS curve. If the Fed rate is at 0% when that happens, problems can be expected.

Comments

[Steve Roth]

So: long VIX?

[Edward Lambert]

VIX?
Volatility index?

[Travis]

What are the problems that you are expecting to occur in financial markets when we hit the LRAS curve and when do you expect them to occur?

[Edward Lambert]

Travis,
You have money freely available to the economy through loose monetary policy, and QE,... when we hit the LRAS curve, production slows down. If money flows into the economy at that point, it is not absorbed by increased production, but the risk is that it would be absorbed by increased prices.
If the Fed sees this happening, in asset prices or core inflation, they will move quickly to control the effects of QE.
I am doubtful that core inflation will rise, so I would expect a bubble to start forming somewhere. Bubbles are de-stabilizing.

[Travis]

Thanks Ed

So we will probably get a bubble in stocks (maybe already happening?). I would guess that its really the aftermath thats the problem then

[Edward Lambert]

Travis,
The effects from real GDP reaching the effective demand limit are beginning to show themselves. The stock market is one sign.