The Progressive Death of the Fed Funds Rate
I started blogging last March. Since then, one of my most visited posts presented a model to show the progressive death of the Fed rate. Basically, the effective zone of the Fed rate is being pushed lower and lower as effective demand declines due to the decline in labor share.
In the following graph, I plot the Fed funds rate on the y-axis and the TFUR on the x-axis. (TFUR, total factor utilization rate = (capacity utilization * (1 – umemployment rate)).
The blue line is the actual Fed funds rate since 1988 in relation to the TFUR. You can see that the blue line has moved within a corridor. The Fed rate rises as the economy heats up from more labor and capital being utilized.
The vertical red lines represent the effective demand limit that has been shifting left over the years. The blue line has been shifting left too because it does not cross the vertical red line of the effective demand limit.
What does this mean? As the red line of the effective demand limit shifted left, the Fed funds rate was progressively pushed down the corridor into a zone of non-traction… a zone of the liquidity trap. It is the progressive death of the Fed funds rate.
You can see that the blue line rose up against the middle vertical red line before falling into the crisis of 2008. Then you can also see that the blue line has been tracking along the zero lower bound and is now reaching the lower boundary of the effective demand corridor. Yet the forward guidance of the Fed is saying that they will keep the Fed rate below that lower boundary. The Fed rate has never gone beyond that lower boundary. Why? Well, the TFUR does not go past the effective demand limit. The utilization of labor and capital will not go much beyond labor’s share of income.
If labor share keeps dropping, the Fed rate will completely die. If labor share stays where it is, the Fed rate will face low utilization of labor and capital for years. But if labor share can increase significantly, the Fed rate will resuscitate and rise back to a healthy zone.
The mechanism… a low Fed rate is designed to create more demand liquidity in the economy. But labor share has fallen 10% since the early 2000′s. A lower labor share decreases the potential of liquidity to return to the economy to where it was. So the low Fed rate is fighting a losing battle in trying to get the economy back to where it was. The relative potential of demand liquidity for consumption is just not strong enough anymore. And pushing a low rate to overcome that limit will create some hefty imbalances.