Praying for Time in the Business Cycle

The business cycle is being incredibly extended with monetary policy. Keeping the Fed rate at the ZLB is increasing effective demand.

But in the end, the effects of a low Fed rate cannot keep the business cycle from closing in on the effective demand limit. They can slow down the process, but they cannot reverse the process.

This graph shows the effective demand limit with and without monetary policy.

Without monetary policy, the business cycle would be screeching to a halt as the green dashed line cuts lower into the utilization of labor and capital (TFUR).

Recent developments in monetary policy from the dropping of the 10 year Treasury maturity rate are allowing the TFUR to rise without effective demand biting into it. But in time, the effective demand limit will bite... and the cost of low Fed rates not disciplining the markets will be paid.

In essence, monetary policy is Praying for Time... but the end of the business cycle will come eventually... George Michael has the appropriate song.

Comments

[Fred]

This is a great piece of work. How long do you think the Fed can string this along. Maybe they can keep effective demand above TFUR for an extended period.
Fred

[Edward Lambert]

Fred,
That is what I am researching now. How long could the Fed string this along?
Much depends on if labor share rises with lower fuel costs, but the 10-year could go down to 1.6% and headline inflation could go down to 1%.
Effective demand would rise another 2%. That would be huge. We could see a resurgence of employing labor and capital.
I do not see a small lift off of the Fed rate having much of an impact in that scenario. The key is those 10-year rates falling and staying low. They can offset a small rise in the Fed rate.