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Real GDP came out today at $15.946 trillion. Here is the projected 1st quarter 2014 update.
Real GDP was lower than trend. It still has not reached the effective demand limit. But it is close.
Potential real GDP is trending squarely on its new normal.
Low inflation in an atmosphere of low nominal interest rates brings up the issue of the Fisher Effect. Here is the long run Fisher equation for a "steady-state" nominal interest rate...
Inflation rate = steady-state nominal interest rate - natural real interest rate
The steady-state means that the nominal interest rate is projected to stay within a narrow range into the future. The natural real interest rate is the natural growth rate of an economy considering such factors as productivity, labor force growth and capital accumulation. The natural real rate is considered independent of monetary policy in the long run.
So how does inflation respond to the steady-state? Does it put up the white flag and surrender to the Fisher Effect or rebel against it?
If the Federal Reserve was to all of a sudden set the Fed rate at a steady-state rate and say that they would hold it there for a long time, inflation and the natural real rate would adjust over time according to the Fisher equation. This adjustment over time is described by a dynamic equation.
A dynamic equation shows changes to variables over time. Many dynamic equations lead asymptotically to a stable steady-state, and some lead to an unstable state. Here is the dynamic equation that I will use to look at the Fisher Effect.
πt = Inflation rate at time period t.
π0 = Beginning inflation rate
π* = Steady-state inflation rate if Fisher Effect is stable
α = autoregressive coefficient, which ultimately shows if the dynamic equation is stable or unstable. In the equation, it is raised to the time period t. When the autoregressive coefficient is between -1 and 1, the equation leads to a stable steady state. When α is greater than 1 or less the -1, the equation does not lead to a stable steady-state and is unstable.
The equation tracks changes in time by raising the autoregressive coefficient to t, the time periods. The equation comes from an ADL model (Autoregressive Distributed Lag). This particular equation assumes that the explanatory variable, in this case the nominal interest rate, stays constant at its long run mean. Since the Federal Reserve is projecting the Fed rate within a low narrow range for a couple years, I assume the Fed rate to be at a "long run steady-state" mean.
The critical variable to test in the above equation is α, the autoregressive coefficient. This coefficient describes the inflation potential in the economy. For example, α will increase when there are factors to support inflation such as rising labor share, rising investment demand, rising consumption, strong fiscal spending, strong currency, low perceived unemployment, destroyed capital and strong labor bargaining power. However, these factors can go against inflation too, which will lower α, the autoregressive coefficient.
When α is between -1.0 and 1.0, the dynamic equation is stable and leads to a steady-state. The Fisher Effect depends upon a stable dynamic equation in order for inflation to trend to its Fisher equilibrium rate.
In this graph, the autoregressive coefficient is 0.94 (less than 1.0). Consequently, we can see that through time, inflation (orange line) is trending toward the Fisher equilibrium inflation rate of 0.5% (blue line). In this case, the Fisher Effect is stable.
When α is greater than 1 we have an inflation rate that explodes upward or downward over time disrespecting the Fisher Effect. (Note: If inflation starts below π*, then inflation will fall instead of rise according to the equation.) Inflation in this case responds to other factors that override the Fisher Effect. In the following graph, the estimated α, autoregressive coefficient, is 1.05.
We can see how inflation keeps rising in spite of the Fisher Effect. In this case, the Fisher Effect is unstable.
One could imagine that the autoregressive coefficient was very high during the Weimar Republic in Germany just after World War I. Even though the nominal interest stayed steady between 3% and 5%, inflation sky-rocketed. There were strong inflationary pressures that overcame the Fisher Effect, such as rebuilding the country to printing money to pay off foreign debt.
Drum roll please... This is the finale.
Now that we have our model, how does current data match up to it? Inflation data (CPI less food & energy) is added to the model for 1st quarter 2012 until 1st quarter 2014.
Inflation is trending fairly well along the path of a stable Fisher Effect. This is evidence that the Fisher Effect is working. Inflation is trending lower so as to raise the real rate (currently -1.2%) to its natural rate of 1.5%. But where exactly will the lower inflation rate become stable? Let's now raise the Fed rate to a projected 3.0% from the 2.0% in the model. The equilibrium inflation rate that satisfies the Fisher Effect will now rise from 0.5% to 1.5% (light blue line rises). The autoregressive coefficient is changed to 0.80 to match the inflation data with a dynamic path.
Even in this case, inflation is following the path of a stable Fisher Effect, but it is not clear how low inflation is trending. Is it trending to 1.5% or lower? The answer depends on the projected steady-state of the Fed rate and changes in inflationary forces.
The Fisher Effect wants inflation to align itself with a steady nominal Fed rate and the natural real rate of interest. Eventually the Fed rate will rise to a long run steady-state around 2.0% according to the Federal Reserve. Thus, the Fed rate will stay low and steady for some years to come. Assuming that the natural real rate is 1.5%, inflation would then keep falling to below 1.0% according to a stable Fisher Effect.
The Fisher Effect currently depends upon weak inflationary pressures. If there were strong inflationary pressures from aggressive fiscal policy or a rising labor share, inflation could escape the Fisher Effect and rise upward instead of fall. There is caution against that type of instability. There are measures to moderate inflation as the Fed's reserves are bloated. It would be safer to keep the autoregressive coefficient below 1.0.
For the moment, inflation is falling along the dynamic path toward a lower inflation rate. So I conclude that α, the autoregressive coefficient, must be below 1.0.
Assuming from the above evidence that the Fisher Effect is active and stable, inflation will go lower the longer the Fed's nominal rate stays near the zero lower bound. If the Fed were to raise the Fed rate, inflation would not fall as much. A higher Fed rate would lead to a higher Fisher equilibrium inflation rate. Theoretically, inflation would stop falling.
The Fed rate should have started rising over a year ago. Low inflation is a big concern. However, raising the Fed rate now is a complicated issue. There would be adverse effects globally. There are economically sensitive reasons to keep the Fed rate low. They don't call it the liquidity "trap" for nothing.
Japan has had its discount rate in the zero lower bound range for many years. If the Fisher effect had any truth to it, we should have seen the real interest rate return back to its natural level of 1% or so. What do we see? (link to updated graph)
The graph shows Japan's central bank discount rate, GDP yoy growth rate, CPI minus food and energy and the real interest rate. The real rate (green line) did in fact return to and stabilize around its natural rate of 1% just as the Fisher effect would expect. This evidence supports the long run Fisher effect.
Inflation did jump up in the late 1990's which looks to reflect GDP reaching its natural level. GDP (red line) rose and then declined transferring the momentum of nominal GDP into prices (violet line).
The real interest rate stayed close to its natural rate from 2000 until the crisis. Then after the crisis, the real rate returned once again to its natural rate until Abenomics pushed inflation up above the discount rate. The real rate fell again.
The question now is... Is the inflation in Japan temporary? Will the real rate return to its 1% natural rate pushing inflation back down? Will Japan's central bank keep the discount rate near the zero lower bound?
Will Japan ever understand the Fisher effect?
Here is a graph just for the real interest rate based on Japan's discount rate and CPI without food and energy.
Noah Smith brought up the issue of the long run Fisher effect. Yet, he wants to see micro-foundation models.
"Specifically, what I'd be interested to see is for someone to find some micro-foundations for the Neo-Fisherite result that don't depend on fiscal policy reaction functions."
He found a paper written by Stephanie Schmitt-Grohé and Martín Uribe where they offer a solution to the liquidity trap using the Fisher effect. They conclude...
"Finally, the paper identifies an interest-rate-based strategy for escaping the liquidity trap and restoring full employment. It consists in pegging the nominal interest rate at its intended target level. ... Therefore, in the liquidity trap an increase in the nominal interest rate is essentially a signal of higher future inflation. In turn, by its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump."
What does "pegging the nominal interest rate at its intended target level" mean? The US Fed would peg the Fed rate at 4% or so, which would imply a 2% inflation target with a 2% natural real rate of interest. In my view, the economy would be much healthier if the Fed had started gradually raising the Fed rate two years ago toward a projected steady rate of 4% to 5%. I would expect a Fed rate around 3% now. Eventually the economy incorporates a 2% to 3% inflation potential according to the Fisher effect.
The approach to raising and then pegging the Fed rate must express a projected "steady-state". In this way, the Fed rate must rise gradually on a steady path to the intended target level where it will be pegged corresponding to full employment. The steady-state then draws the broader economy to it. The ultimate goal is to reach and hopefully maintain a steady-state at full employment. Whether or not capitalism has the nature to maintain a steady-state at full employment is a larger question.
Yet, the logic that raising the Fed rate in the US would lead to higher inflation and full employment seems bizarre and dangerous to most. Raising the Fed rate would throw the US into recession, wouldn't it? How can we understand the micro-foundational mechanisms for this Fisher effect? Well, it is not a straight-forward endeavor.
They are so many chaotic forces that want to push the Fed nominal rate off of its steady-state path. Those same forces push inflation too. The institutional dynamics within every economy vary greatly. Thus, the long run Fisher effect will manifest in many different and wild ways. Here's a few micro-foundational factors...
Beyond micro-foundations, one would also consider the aggregate structure of the macro-economy. Here's a few macro factors...
All the above factors can interact in innumerable ways. One has to look at each economy on a case by case basis to develop an individual model of how inflation would adjust in the long run to a "steady-state" nominal interest rate and a "steady-state" natural rate of interest.
Ultimately the Fisher effect depends on the level at which an economy expresses a steady-state within a multitude of chaotic forces.
If you were a passenger in a car speeding toward a cliff, you would scream at the lunatic driver to steer away or slow down. The car is our economy. The cliff is inequality. Inequality is a disaster for society.
Who is driving the car? A combination of government policies and business institutions are steering the car toward inequality. We see low taxes on the rich and norms for higher and higher CEO pay. We see the real wage struggling behind productivity. Changing these policies would steer us away from inequality.
What has been making the economy go so fast toward inequality in these last 2 years? ... Monetary policy is the engine of the economy. When you push down on the gas pedal (interest rates), the car (the economy) goes faster. The speed at which we are generating inequality is largely based on monetary policy. And our long run aggressive monetary policy is speeding toward inequality.
Monetary policy mostly depends upon the wealth effect to boost demand. Yes, the Federal Reserve has programs to direct liquidity into communities, but the larger impact of monetary policy is still the wealth effect through QE and the zero lower bound Fed rate. Productive investment is muted due to low labor consumption power. The wealth effect is a fast track to inequality when the economy is being steered toward inequality. If the economy was being steered toward a healthy balance between labor and capital, monetary policy would be benefiting broader society.
Words from Jeffrey Snider at Alhambra Investment Partners.
"That is because the “wealth” effect has nothing to do with wealth at all, rather it is properly defined as an inflation/credit system. Thus any relationship between asset inflation and consumer spending is indirect."
"... we need to stop focusing on monetarism and credit, and instead allow direct economic expansion through the wages of actual capitalism. This convoluted monetarist system is simply too inefficient to sustain and nurture long-term economic success."
If the government is unable to tax the rich.. if businesses are unable to raise labor's real wages faster than productivity growth... if business is unable to lower CEO pay... if off-shore tax havens are not controlled... in essence, if the economy cannot steer away from inequality, can central banks at least slow down the speed at which we head toward inequality?
Society needs time to form a proper response to growing inequality.
Low inflation continues to be a concern in Europe and the US, especially in Europe. Central bankers project that inflation will rise as the economy gets closer and closer to full employment. Yet, what is behind low inflation?
I refer to the work of Michael Pettis who is a professor of finance at Guanghua School of Management at Peking University in Beijing. He puts low inflation in China within the context of financial repression.
"...why is it that what seemed by most measures to be an extraordinary surge in money creation did not also result in significant wage and consumer price inflation?"
"The answer, I will argue, has to do with the nature of money growth in financially repressed economies. Because the Chinese financial system is so severely repressed, money growth in China cannot be compared to money growth in a market-based financial system. Monetary growth is effectively bifurcated and affects producers and consumers in very different ways."
"What does it mean to say that monetary growth was bifurcated? By this all I mean is that nominal money growth showed up as different rates of money growth for different parts of the economy. More specifically the rate of monetary growth for producers exceeded the rate of monetary growth for consumers, and this becomes clear by measuring the monetary impact on different sectors within the economy of monetary expansion under financial repression."
"Countries with significant financial repression can experience periods of rapid monetary expansion with results that do not conform to normal expectations precisely because of this bifurcation in the monetary impact of credit creation. On the production side of the economy it is easy to see in China over the past decade what looked like the consequence of rapid monetary expansion – rapid growth in credit, rising productive capacity, surging production of manufacturing goods, asset bubbles, etc.
"On the demand side of the economy, however, and especially considering household consumption, one gets a very different view – monetary expansion seemed to have been very subdued. Household consumption typically grew much more slowly than GDP and its share of GDP declined steadily. Consumer price inflation also tended to be low or moderate even in the face of what seemed like rapid monetary expansion."
Financial repression is not recognized in the US. However, there is a monetary bifurcation related to labor share. And in China over the last 16 years, along with financial repression labor share fell in China by quite a lot. Andrew O’Connell pointed that out today. He cites that in Guangdong, labor share fell 20% over 10 years. Capital share would have risen 25% as a result. That is a large bifurcation in monetary potential.
As labor share falls in the US and Europe, is household consumption also being subdued by a bifurcation in monetary expansion? Yes... We see consumption by capital income rising fast, while consumption by labor income is extremely weak. (source) This is evidence of bifurcation.
US Nonfarm business sector Labor share fell from 109.6 in 2000 to currently 96.6. (source) That is a 12% point drop, which is comparable to how much labor share fell in some parts of China over the same time period. And if you assume an actual economic labor share drop from 75% to 66% (a 12% drop), capital share then rose from 25% to 34% (a 36% rise!!!).
What is behind low inflation? ... Monetary expansion is bifurcated.
I just watched the debate between Mark Thoma and Steve Williamson. (youtube video) As I see it, the main issue was the direction of causality in the Fisher equation. In the end, I agree with Mr. Williamson.
The basic Fisher equation is...
Real rate = nominal rate - expected inflation
As the real rate is said to be independent of monetary policy in the longer-run, the nominal rate and the expected inflation move together as time goes by.
So if the real rate wants to be -1% for instance, in the long run you would see either of these two outcomes...
-1% = 0% - 1%
-1% = 2% - 3%
In the second equation, expected inflation is higher. How did that happen? Was it because the nominal rate rose?
During the debate, the question came up whether to raise the nominal Fed rate or not. Mr. Williamson, who is in favor of raising the Fed rate like me, said that expected inflation will follow the nominal rate in the middle and long-run according to the Fisher effect. The basis of this idea is that the real rate is independent of monetary policy in the longer-run... such that the nominal rate will guide the expected inflation rate. The opposite direction of causality happens in the short-run.
Mr. Williamson implies that a higher nominal rate of 2% would guide a 3% expected inflation rate through time. The other implication is that the low nominal central bank rates we see around the world have led to low inflation rates by the same long-run guiding effect in the Fisher equation.
Mr. Williamson made a case that the short-run effects of monetary policy have worn off. And since we are now in the long-run of monetary policy, expected inflation is low because it seeks balance with the low nominal rates. I agree with him. And I also agree with him when he says that inflation will not rise as central bankers say it will.
I have been calling for tighter monetary policy for a different reason, because according to my research of effective demand, the output gap is much smaller than the CBO says. I see we are reaching the end of the business cycle. Some $100 billion more in real GDP and the spare capacity is all gone. This leads me to want tighter monetary policy. Yet, Mr. Williamson takes a different yet complementary approach to raising the Fed rate.
He acknowledges that there would be a short-term adverse reaction to raising the Fed rate, but then as that wore off, expected inflation would rise with the natural business cycle dynamics. Inflation is what economists like Mr. Thoma and Mr. Krugman want. But they want inflation to drive the real rate lower. But if the real rate is independent of monetary policy in the long-run, holding the Fed rate at the zero lower bound will not lower the real rate, but rather lower inflation, according to Mr. Williamson. The real rate edges higher. This is actually what we have been seeing.
There is a natural tendency for the real rate to rise during the expansion phase of the business cycle. So as the economy is now reaching the natural level of GDP, the real rate, which is negative, wants to rise to around 2%, where it would be naturally balanced. Keeping the nominal rates low means inflation will go lower as the real rate rises naturally. Yet,, inflation meets resistance as it goes toward 0%. So the real rate stays negative and can't rise to its natural level. Outright deflation would allow the real rate to rise to its natural level.
Monetary policy is manufacturing an abnormally low real interest with the hopes of pushing GDP back to a higher level. It is an unnatural process. Mr. Williamson sees a higher Fed rate as a natural process, which would allow both inflation and the real rate to rise to their natural target levels in the long-run.
Mr. Thoma responds to this by giving the opposite direction of causality in the Fisher equation. He implies that expected inflation always drives the nominal rate, in the long-run and short-run. So Mr. Thoma says that inflation has to rise first as an overall general principle in order to raise the nominal rates, whether short or long-run. In such a case you have to generate demand first to generate inflation.
Mr. Thoma says that best way to increase demand is through tax incentives for investment. I do not like this approach because consumption demand by labor has to come first before business investment will pick up.
So, who is right? While Mr. Williamson says the direction of causality between nominal rates and expected inflation can go both ways depending on short or long-run. Mr. Thoma says the direction of causality goes only in one direction.
In the end, it is Mr. Williamson's distinction between the short-run and longer-run equilibrium effects of the Fisher equation that wins out. Holding the central bank rates low for so long caused the low inflation problem. The way to get the benefits of higher inflation and a natural real rate is to raise the nominal Fed rate, accepting a temporary period of economic contraction in the short-run.
Related post:
Williamson, Stephen. Phillips Curves and Fisher Relations. Stephen Williamson: New Monetarist Economics. December 15, 2013.
The Board of Governors of the Federal Reserve System has adjusted many figures for capacity utlization going back some years. They lowered the figures. What do those adjustments mean to calculating effective demand? Mostly it means that there is more spare capacity than I originally thought. Well, let's look at some basic charts updated to 4th quarter 2013...
Note: The conversion for effective labor share from the "Non-farm Business Sector: Labor share index" has not been changed. It is still 0.762.
First the UT index which is a measure of the spare capacity between utilization of labor and capital and effective labor share. As the UT goes to zero, real GDP is reaching the effective demand limit. (This graph is always visible and automatically updated in the upper right corner os this blog.)
What we see is that the UT has not yet reached zero. Before the adjustment to capacity utilization, the UT index had reached zero and even gone a little negative. After the adjustment, there is more spare capacity than seen before.
Let's look at the output gap...
The output gap has not changed much. It is still reaching a normal level.
A big update comes with the chart for showing the natural rate of unemployment...
The natural rate of unemployment is now shown as 6.8%. Before the adjustment, it was 7.1%. That is a big change. Now I must update my prediction for how low the unemployment rate will go. It will still not go as low as 6.0%. Most likely the unemployment rate will bottom out at 6.3% to 6.6% considering that monetary policy will not tigthen.
It is so nice to have better numbers that coincide with the economy. The current unemployment rate is much closer to what the graph above would predict. Unemployment was 6.7% in the first quarter of 2014, so I would roughly estimate that the UT index will come in close to zero for that quarter, which would mean that non-farm labor share would once again be near its all-time low since WWII.
But the general picture remains, real GDP is closing in on effective demand. There is a bit more spare capacity than I thought a week ago though.
Capacity utilization data was revised today. So I revised some graphs. Here is the path to the effective demand limit.
The economy is reaching the effective demand limit now. What will we see? The economy will heat up. Unemployment and capacity utilization will improve. Labor share should increase, we will wait to see how much. Inflation should pick up in about 3 or so months depending on whether labor and capital consumption can increase together.
But a recession will not happen right away as these lines hit. Normally GDP output does slow down, but there are other adjustments that forestall an outright recession. Basically the lines will dance together a bit.
UT Index (measure of slack):
z-vertical:
z derivatives in terms of labor & capital:
Effective Demand, real GDP & Potential GDP:
ED Output Gap:
Corporate profit rate over real cost of money:
Exponential decay of Inflation:
Measures of Inflation:
YoY Employment change:
Speed of consuming slack: yoy monthly:
Speed of consuming slack: quarterly:
Real consumption per Employee:
Will real wages ever rise faster than productivity?:
Productivity:
Productivity against Effective Demand limit:
Bottom of Initial Claims?:
Tracking inflation expectations:
M2 velocity still falling:
All in one:
Double checking labor share with unit labor costs & inflation:
