Projecting A Fed Rate Path

Last week the markets moved. Bonds yields went up. Stocks went up. Inflation expectations were awakened.

What will the Fed funds rate do? How might the Fed respond?

I will do an analysis to project a path for the Fed Funds rate based on my research into effective demand. (a synopsis of the research.)

Effective Demand

Effective demand is basically a limit upon the utilization of capacity determined by labor share. As labor share falls, the optimal utilization level of capacity also falls. We have seen labor share fall. At the same time capacity utilization trended lower. My research into effective demand is built upon the following graph. 

Profit Rate Cycle

The original description that Keynes and others gave for effective demand pointed to profits as the driving factor. Once entrepreneurs see profit rates peaking, they will stop utilizing labor and capital because if they did not, profit rates would decline.

My models of effective demand track the profit rate cycle. (link)

The profit rate cycle tracks the business cycle. The following graph gives a profit rate based on profits in relation to GDP. (link to FRED data)

The profit rate rises and then falls in each business cycle between recessions. It would appear that this business cycle is nearing its end.

Markets after Trump victory

As I started this post, I mentioned the moves in markets during the last week. There is revived hope of getting the economy going again. Trump promises fiscal expansion, deregulation and lower taxes. In short, there  seems to be a business expansion being revived using supply-side strategies.

It is not common in the profit rate cycle (graph above) for profit rates to climb back up to two major peaks before a recession. But let's assume that this business cycle can be revived without a recession taking place. What might that look like?

Path of Labor & Capital

In the model of effective demand, capacity utilization is optimized at the effective demand limit. Profits from the utilization of capital are maximized. Entrepreneurs see that profits cannot be extended, so utilization of their capital is held back.

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Gary Anderson 8 months ago Contributor's comment

Prof, Alan #Greenspan has been reading you. He says #stagflation is his fear, which you seem to be saying as well. Killing the collateral could make things even worse than that.

Edward Lambert 8 months ago Author's comment

Alan #Greenspan was masterful in his monetary policies. Yes, you could say that I am seeing the possibility of #stagflation. There is #inflation potential but not much output potential. Yet, I tend to see it not lasting very long, before a contraction takes hold. And Gary, you make a great point about the risk of killing the collateral, which is a headwind against output growth as interests rise.

Barry Hochhauser 8 months ago Member's comment

I couldn't agree more.