I have posted this model of core inflation before. Core inflation on y-axis. Corporate-after-tax profit rate minus nominal rates on x-axis.
The model implies that inflation depends upon the difference between an aggregate corporate profit rate and nominal rates. The more nominal rates cut into corporate profit rates, the more corporations would choose to raise prices to maintain "net" profit rates... and thus create inflation.
Olivier Blanchard and Adam Posen wrote last December in 2015 an article titled, Japan's Solution Is to Raise Wages by 10 Percent. As wages rise, corporate profit rates come down. So if you want to cut into corporate profit rates but cannot do it by raising nominal rates, then do it by raising wages. Either way, the data points move left on the x-axis making inflation increases more likely.
Olivier Blanchard and Adam Posen give the logic of the model when they say in their article...
"The point is not to redistribute income from business to labor. If anything, employers and other price setters should be encouraged to pass on the increased costs from wages to consumer prices and try to maintain their profit margins."
The key to inflation is making corporations try to maintain their profit margins. But supply-side economics has lowered corporate taxes, lowered minimum wages, weakened unions and more in order to raise corporate profit margins. Is it any wonder that inflation will be low for years to come?
Here is a graph from FRED showing monthly percentage movements of core inflation. (link to data)
There used to be ranges that core inflation moved within. The monthly change either hit the maximum of that range or the minimum with some breakout movements in between. Monthly movements made sense by looking at 12-month moving averages.
Since about the year 2000, the visible ranges have disappeared. The monthly movements are more free-form. Thus monthly core inflation numbers should be more accurate now. However, there is still noise in the movements which belie that prices are sticky and should not change so erratically.
The best way to view monthly inflation numbers is with "Annualized" moving averages as Tim Duy does. Here is an example from Tim Duy.
Look at the time period from mid-2010 to mid-2011. You see large positive monthly movements in the second half of 2010 but the 12-month moving average was rising much more slowly. In the first half of 2011, inflation was coming down, but the 12-month moving average was still rising and kept rising until mid-2011. So the noisy monthly movements were designed to keep the 12-month moving average on a steadily rising trend.
Discerning the correct and steady trend of core inflation is the key.
Back in the early 80's, my undergrad teacher would use an 18-month moving average. But if we knew which monthly moving average is being manipulated on a monthly basis, we would understand each monthly change better.
Here we have quarterly data since 1958. That is 234 data points! Inflation has stayed within the range filled in with red for all those years.
In this graph, we see the last 8 quarters of data highlighted in red. Corporate profit rates have fallen some. The mixed nominal has actually dropped a bit too, but corp. profits rates have dropped more.
The dark blue arrow marks the predicted upper limit of core inflation according to the pattern set up in the model.
So the model predicts that core inflation will ride along or under this upper limit of around 2.2% as the data points move left on the graph.
Does core inflation show signs of moving along the upper limit?
Here is core inflation over last 8 quarters (monthly data)...
Core inflation rose to around 2.2% and looks to have stabilized at the upper limit in the model above. I predict that core inflation will continue to follow closely to the projected upper limit.
"But if monetary policy is being successful we expect inflation expectations and growth expectations to increase. Both of these forces should push long-term interest rates higher not lower! Something is fundamentally not working when it comes to monetary policy and it is either the outcome of some forces that the central banks are unable to counteract or"
I stop right there. For me, there are forces that the central banks cannot counteract. And the new model is revealing some preliminary mechanism to show how.
I applied the model to Japan's situation of low inflation and low nominal rates.
The model builds on the idea that capacity utilization is a force that affects inflation. The current low capacity utilization is a force to push down inflation.
Another force is net profit rates (corporate profit rates - nominal rates). High net profit rates also push down inflation.
Another force is labor share. The current very low labor share in advanced countries, including Japan, leads to an environment where inflation wants to go lower.
So now I input some preliminary data into the model for Japan.
Natural real rate is negative = -0.6%
Effective labor share = 70%
Capacity utilization optimized at 5% unemployment
Adjust exponential equation of core inflation to allow for deflation, i = 0.036 * e(-13*net profit rate)– 1%
Here is the model assuming a 2% inflation target...
Two things to note here...
The central bank nominal rate (solid red line) stays at the zero lower bound almost up to the natural limit of capacity utilization (vertical green line)
Core inflation hovers on the edge of deflation the whole time up to the natural limit.
Even by keeping nominal rates low, inflation still stays low. Antonio Fatas talks about forces. Here we see the forces at work.
Now I solve for the inflation target that brings monetary policy into balance with the forces.
Look at the horizontal dashed green line of the inflation target. It now sits at -0.3%. The model shows that a mild target of deflation is the best monetary policy to balance the forces affecting inflation.
Also note that the base central bank nominal rate sits at the zero lower bound all the way to and past the natural effective demand limit. (vertical green line)
The model reflects the situation in Japan. Loose monetary policy cannot counteract the forces that want to go into balance at a mild deflation level.
Keep in mind that the model probably needs some tweaking to get coefficients right, but the model can explain forces that Antonio Fatas mentions.
The success of Abenomics depends upon raising labor share. A higher labor share would raise the balanced inflation target. I and others have said this from the beginning. This model gives a logic behind the view..
I continue to explore the model that I posted this morning extending a relationship between inflation and capacity utilization. The model shows that labor share would determine the most balanced inflation target... and the inflation target then becomes variable depending upon the how labor share changes in the economy.
Remember, it was once thought that labor share was pretty constant. Now that it has fallen so much over the past 15 years, we can study its impact better.
One can read the previous post to see how the model is built.
I want to focus on two points in the model.
The crossing point of the nominal interest rate (solid red) and the normalized nominal rate (dashed red line).
The crossing point of estimated inflation (solid yellow) and the inflation target (dashed green).
Both of these crossing points should occur at the natural limit (vertical green line). They should define balance at the natural effective demand limit. Greenspan did a good job of getting these two pairs of lines to cross where they should at the natural limit back in the 90's. We are far from doing it now. But how can it be done? The answer is in labor share.
Let me put up a graph with an effective labor share of 75% with an inflation target of 3%. (Natural real rate is 2% throughout. I have removed the profit rate and net profit rate so that the lines in question can be seen better.)
In the graph, the first pair of lines cross at 5% at the natural limit (vertical green line) as they should, but inflation is coming in below target at the natural limit (yellow line below dashed green). The dynamics of the relationships are calling for a lower inflation target to have balance at the natural limit.
Now I lower the inflation target to 1.84%.
Now the two pairs of lines cross perfectly on the natural limit. What is interesting is that effective labor share was around 75% in this business cycle, implying that an inflation rate below 2% was balanced. That is what we have been experiencing.
Now what if we wanted to always have an inflation target of 2%, but let effective labor share rise back up to 80%?
Now we see that inflation wants to be above target at the natural limit (yellow line is above the dashed green at the vertical green line).
So now I raise the inflation target to 3%.
Now the two pairs of lines cross perfectly in balance at the limit.
The model says that as labor share rises, the inflation target should rise too so that the Fed rate and inflation arrive at the natural limit in balance with monetary policy. So in order to have balance, we need to be able to adjust the inflation target as needed.
Or could it be that an inflation target itself drives labor share and inflation toward the balance point? Just a thought blowing in a brainstorm.
So is their a relationship between labor share and inflation? Here is a scatter plot of actual quarterly data since 1967.
Lo and behold! There is a relationship between labor share and inflation. And it fits the model... I love discovering hidden secrets.
According to the trend line of past data, an effective labor share of 75% would call for an inflation target around 2%. This is close to the model I am presenting. And an effective labor share of 80% would call for an inflation target around 3% to 3.5% which is also close to my model.
If effective labor share ever gets back up to 84%, an inflation target of 5% to 6% would be called for. If we tried to keep even a 3% inflation target, inflation would constantly be trying to rise above our target in an uncontrolled way... 1970's anyone?
The high data points from the 70's may be just from a dynamic of high labor share that wanted inflation above an inflation target that was too low at the time. Then there could have been two basic ways to solve the high inflation.
Raise the Fed rate a lot which Volcker did
Raise the inflation target, which would have been even less acceptable.
Now low inflation in the advanced world may simply be a dynamic result of labor share being forced down around the world.
So there you have it... Which came first, the inflation target or the inflation? Well, that could depend on effective labor share.
I have been in the workshop building a model for inflation, capacity utilization and other things. It builds upon the model for forecasting the profit rate cycle. And also upon the model for the relationship between inflation and net profit rates. The model was provoked by a video from Khan Academy on youtube.
This model has many working parts so I will build it slowly.
Effective demand limit & Peak profit rates
When profit rates peak in the aggregate, we have reached the effective demand limit. Capital utilization has been optimized. Think of the effective demand limit as the Natural limit of the business cycle in terms of capacity utilization, not full employment of labor.
Effective demand upon capacity utilization = s/u = 79.4%
c = capacity utilization
u = (1 - unemployment rate), unemployment rate of 5.6% used for graph
s = effective labor share, (0.76 * Non-farm labor share index), s = 75% for graph.
Capacity is optimized at the effective demand limit. Capacity utilization does not like to go beyond the effective demand limit because profit rates fall. This is the pattern since 1967, the year data for capacity utilization starts.
Estimated Fed Funds Rate
Now I add in the equation for estimating the Fed funds rate path based on the effective demand limit.
Effective Demand Fed funds rate estimation = z(c2 u2 + s2 ) - (1 - z)(cu + s) + t
z = (2s + r*)/(2s + 2s2)
t = inflation target, 2% used for graph
r* = natural real rate, 2% used for graph
The orange line sets an appropriate rate for the Fed funds rate based on the cycle of effective demand. However, that rate can change as the forces around inflation change. I will discuss this a bit later below.
Note how the orange line crosses the effective demand limit at 4%, which is the natural real rate plus the inflation target. So the Fed rate is modeled to be normalized at the effective demand limit. I have drawn in the normalized Fed rate line at 4%.
Net Profit Rate
Now I add in the net profit rate.
Net profit rate, n = Profit rate - nominal rate
Net profit rate drops as the Fed rate rises.
Now I add in the trend of core inflation.
Estimated core inflation, i = 3.8 * e(-0.127*n*100)/100
Inflation is estimated from the net profit rate, n. See this post for example of equation. The coefficients above were chosen to weed out some of the effect of the Volcker recession and to make inflation cross the effective demand limit at the inflation target of 2%.
Note that inflation is less than the 2% target to the left of the effective demand limit. The equation above for the estimated Fed rate assumes that inflation is on target at 2% because no adjustment is made in the equation for inflation off target. The implication is that there is a tendency for inflation to want to go below target when capacity utilization is low and when net profits are high.
The main point of the video by Khan Academy is that inflation tends to rise when capacity utilization is high, but I would also add that net profit rates need to be low too. The other point in the video is that inflation will stay low when capacity utilization is low. I would also add there that net profits need to be high.
Here is how the graph changes just after two iterations if the Fed rate tries to adjust to the tendencies of inflation to be off target.
First, note how the Fed rate waits longer to start rising off of the zero lower bound. Look familiar? Then it has to rise faster to normalize.
Inflation drops just a bit when capacity utilization is below optimal, and rises much faster when beyond optimal. The current stubborn low inflation reflects this model.
Many people criticize the Fed for keeping the Fed rate too low as a recovery gets going, but there is a reason to their madness. They are dealing with forces that try to push inflation lower. Especially now since capacity utilization is very low and net profits are very high. Both add to pressure to keep inflation low. The problem with the Fed is simply that they do not know where the effective demand limit is.
Real Profit Rate
More important than the net profit rate is the real profit rate. Firms look at this in order to invest, set prices and manage their profits.
Real profit rate = n + i = net profit rate + core inflation
Firms keep the real profit rate above zero. The aggregate real profit rate does not like to go below zero. So you see it dropping toward zero beyond the effective demand limit.
Here is the same graph above adding the real profit rate when the Fed rate tries to adjust to strong forces pushing inflation off target.
The real profit rate will drop faster around the effective demand limit as the Fed rate rises faster. Then inflation will rise faster on the right of the ED limit to keep the real profit rate positive. In the graph, the real profit rate slams on the brakes and starts rising again as inflation keeps it above zero. Aggregate profit rates are still dropping, but an immature economy may simply keep increasing capacity utilization as long as the real profit rate is positive. The result is high inflation.
The model is a handy way to gauge where the economy is. The model is a good way to see the forces pushing inflation off target. And the foundation of the model is the aggregate profit rate, which drives the economy as well as sets the effective demand limit upon the business cycle.
The plot has hugged and slid along two resistance lines since 1958. Below there is resistance to fall into deflation at the 0% inflation line. To the left is a resistance line for a 0% profit rate over the real cost of money.
Let me explain how that real cost of money boundary is calculated.
So the profit rate is 2% over the nominal cost of money. But then we make core inflation -2% to take away that net profit rate.
Core inflation = -1 * 2% net profit rate = -2%
Zero real profit rate = 2% net profit rate + -2% core inflation = 0%
So basically the line with a -1 slope that crosses through the origin of the x and y axes, gives the line where real profit goes to zero %.
ok... back to the graph...
How might we explain the steadfast movement of the data points along the two resistance lines.
Well, we know that there is a resistance to fall into deflation, and there is resistance by corporations to have negative real profit rates.
How can we view the forces at play?
There are forces to increase profits which try to push the data points away from a 0% real profit rate.
There are forces which counteract the forces to increase profits, namely, labor power, perfect competition and price inertia.
These counterbalancing forces work against the forces by corporations to increase profits for themselves.
So for 58 years, the pattern has been solid. The data points moved within a definable range.
Could the data points break out into a new pattern farther away from the resistance lines? I do not think so... It has never happened in 58 years of data. The forces are pushed into a balance in the range defined by the red zone in the graphs.
4% Inflation Target?
So what if the Fed tried to have a 4% inflation target, like Paul Krugman advises? The zone of a 4% inflation target would probably be like this...
As the green zone sits at a net profit rate of 0%, we could logically conclude that the nominal cost of money would equal any corporate profit rate as a general rule. So if corporate profit rates get back up to 9% in the next recovery, we would assume a nominal interest cost over 7% so that the forces are balanced at a 4% inflation target.
There would never be a nominal interest rate of 7% if inflation was 4%. It is not going to happen. So then we assume a nominal interest rate of 2% to 4%, which would imply an upper limit on the corporate profit rate in a range of 2% to 4%. So corporate profit rates would have to come down a lot in the next business cycle.
Corporations are going to fight tooth and nail against the 4% inflation target.
What about a 2% inflation target?
Actually a 2% inflation target feeds right into the hands of corporations. They can have profit rates above 9% and the forces still be balanced along the 0% core inflation line. The Fed helps them by keeping nominal rates near 0%. Higher profit rates lead to lower labor share and lower effective demand.
The forces from corporations to push net profits as far right as possible have succeeded greatly in the last two business cycles. But they have succeeded too well, and the economy is sick because of it.
A 3% Inflation Target?
A 3% inflation target would be met with nominal rates from 1% to 3%, which would imply corporate profit rates in a range of 3% to 5%. This is a healthier balance than what we have now. And healthier than a 4% inflation target which implies a monetary policy tending to seem too tight.
It seems more reasonable to have a 3% inflation target. Then net profit rates would be mostly positive and very high corp. profit rates would be avoided. Lower profit rates would imply higher labor share, which would increase the Effective Demand on the business cycle. Then there would be higher utilization of labor and capital.
The main idea is that a 3% inflation target would better avoid the part of the zone that slides rightward holding inflation rates at low levels. Then the Fed thinks they have to keep nominal rates low to try and raise inflation. But the inflation rate is basically just stuck in a balance between the forces described above.
A 3% inflation target would lift us out of that low level inflation zone and give us moderate nominal rates. Corporate profit rates would be healthier for the economy as a whole.
So it is a good idea to raise the inflation target. The graphs above suggest that a 2% inflation target is too low, a 4% inflation target is too high, and a 3% inflation target would be more balanced.
The big question is... How do we get out of this rut of low inflation levels? I think the Fed has to raise nominal rates to start bringing down net profit rates, so that corporations feel the need to use the force of inflation (y-axis) to support their profit rates.
Data as of 2ndQ-2016
Effective Demand = $17.401 trillion
Real GDP = $16.570 trillion
Productive Capacity is rising to next business cycle = $23.170 trillion
UT index is rising = +4.3%
demand limit = 75.8%
TFUR = 71.5%
ED Fed rate rule (down from a peak of 3.7% in 2014) = 1.7%
Estimated Natural Real Interest rate = 1.6%
Short-term real interest rate (fallen from 2.7% peak in 2014) = -0.2%
There is no recession for 2ndQ-2016. Risk is growing to see recession before end of 2016. I am expecting a recession by the middle of 2017.
(UT index is rising which implies a recession is on the way.
Click on Graphs below to see updated data at FRED.
UT Index (measure of slack):
Recession Alert (developed at recessionalert.com):
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?:
Real Wage Index:
Productivity against Effective Demand limit:
Bottom of Initial Claims?:
Tracking inflation expectations:
M2 velocity still falling:
Double checking labor share with unit labor costs & inflation: