AUGUST 18, 2019
We have wanted to supplement our Fiscal Policy and Monetary Policy (the Fed Interest Rates and GDP) videos for quite some time. Unfortunately, we’ve been pressed to handle other matters. Below Is generally where we are headed with that video.
We are hastening to do this because since those videos were produced we’ve had: (i) a huge Trump tax cut (last year); (ii) Brexit (vel non) is looming but not certain, (iii) we have ships being detained on the High Seas in the strategic Strait of Hormuz (Iran, oil, nuclear proliferation issues et al.); (iv) the U.S. and China seem to be engaging in an increasingly nasty tariff/trade war. This is not to mention that the Dow has just dropped 800 points.
Economists have traditionally worried that when the Federal Reserve Bank (the Fed) increases the money supply that there was an increasing risk of inflation if the increase in money supply occurred at a point where the economy was at or near “full employment”. To most economists “full employment” traditionally meant that point in where aggregate demand and aggregate supply yielded a gross domestic product (GDP) where the unemployment rate was 5% or less.
The five percent figure has always been at least a little bit controversial, if not somewhat arbitrary.
The reason that economists felt that full employment occurred at a level of something greater than 0%
is that there will always be a certain number of people temporarily “between” and/or switching jobs, or people who voluntarily elect not to get a job etc. etc. And then there’s the issue of how to count people just working part-time jobs and the existence of workers that we don’t even know about (immigration issue) etc., all of which complicate the determining what full employment truly is. On top of all of these complicating factors, there’s a problem in getting reliable statistics on how many people are actually unemployed. Are the government’s statistics accurate?
Recall (from our previous videos on Fiscal Policy (the Fiscal Video) and the Fed, Interest Rates and GDP (the Monetary Policy Video) that aggregate demand and aggregate supply are two lines on a graph (which is/are illustrated in those videos) with the graph having a horizontal axis (the old “x” axis from high school math) and the vertical “y” axis. Recall that on the “x” axis there is depicted “Q” which denotes the quantity of goods and services produced in the nation. Thus, as more goods and services are bought and sold one moves out to the right on the Q axis.
Conversely, on the left “y” vertical axis, “price levels” or “P” are depicted, starting at zero. In fact, the P value and the Q value are both at zero where the Q or x axis cross and P or y axis cross. On this “P” axis as prices go up one moves higher and higher up the “y” axis, which indicates higher and higher “price” levels.
Aggregate demand increases as prices go down. Thus, generally the aggregate demand (AD) curve starts high on the upper left and when prices go down the Q values increase. The AD curve (it’s called a curve but we use a strait line for simplicity) is thus downward sloping as you move from left to right.
Conversely the aggregate supply (AS) of goods and services bought and sold in the U.S. increases as prices go up. This is because if prices go up producers want to produce more. This means that the “AS” curve (again we call it that but we use a very slightly sloped straight line to reflect the AS curve but as we move right at some point—that is, at full employment- the AS curve bends like an elbow (at RnB we call it the “elbow”) and starts to steeply run in an increasingly more vertical direction. So that, theoretically if the nation really did reach full employment (0 % unemployment in fact) the AS curve would be perfectly vertical because no more goods and services could possibly be produced—all workers and resources were being totally utilized. It is on this more vertical area (after the 5% full employment point) where steep price increases (inflation) should occur.
Note that gross domestic product (GDP) for the nation is located at the point where the AS curve and AD curve intersect. In other words, where those curves intersect determines the total output of all goods and services bought and sold and the price level achieved/paid in the entire U.S. economy generally.
As has been noted, the elbow in the aggregate supply (AS) curve has been thought by economists to be at about 5 % unemployment. However, that may or may not be true. However, in any event, the correct and/or true location of that elbow, whatever the real level of full employment really is, (be it 5percent, 3 percent, 2 percent or 10 percent) has a major effect on when inflation should kick in if the Fed expands the money supply (MS).
Why is the “elbow” in the AD curve there? Briefly because if we are truly employing
all available workers and fully employing plant and equipment to maximum capacity then most economists say that any attempted increase in economic level will require “employer a” to offer higher wages to his workers than “employer b” otherwise they will leave. At full employment workers are in short supply which means they can easily negotiate higher and higher wages. This has a ripple effect of driving prices generally higher and higher very quickly but….importantly…doing so without any increase in the level of GDP. (that is, q on the “x” axis stops increasing because more cannot be produced) Why? Because GDP can’t go higher because everyone is by definition employed at full employment and already working the maximum hours etc.
However, if the elbow is really at 3 percent or less (because 3 % is full employment and not 5%) then expanding the money supply (ms) when unemployment is actually at 5 percent will probably cause little if any significant inflation. consumers will notice very little in price increases at the store.
(Perhaps that is the actual situation that the United States has been facing. But then again, maybe not.)
If the elbow (full employment) is at 4 percent and unemployment is really at 4 percent then expanding the money supply should under traditional economic theory cause inflation. perhaps even a lot of inflation. Why? because we are entering the steep vertical part of the as curve past the elbow. doing that pushes prices higher. And, if and as the Fed tries to expand the money supply from their consumers should, under traditional theory, see prices rise dramatically. In fact, the economy will overheat, which will eventually lead to the negative consequences associated with quick price hikes. A negative economic snowballing effect should start with existing wage levels quickly becoming inadequate to pay the quickly escalating prices associated with inflation. Fixed income seniors will suffer. Soon, unless corrective actions are taken other more serious consequences would follow that could lead to recession or worse.
Now switch gears. Going back to our fiscal policy video and discussion, recall that Congress and the President must jointly agree on taxing and spending decisions. If they agree on a budget that creates a deficit (where the government’s cash outflows (for Defense, Medicare, etc. etc) exceed its tax revenues) then that deficit has to be financed usually borrowing the money from U.S. Treasury bondholders. This occurs when people, firms and even some foreign countries buy U.S. Treasury bonds—which of course, are nothing buy the U.S. government’s I.O.Us to the people who buy U.S Treasury bonds. In essence, the people who buy the government’s bonds are loaning money to the U.S. government.
As we previously discussed the Fed performs vital functions in the U.S. government’s borrowing process that finances federal deficits. It is important to note that all federal budget deficits must be financed by this process.
The importance of this is that despite the fact that the Fed was legally established to act independently of the political control of the President or the Congress, the Fed, often has no real choice but to help finance federal deficits. Why? Because, as an all too real practical matter, the Fed realizes (if cooler and rational heads are prevailing) that a shutdown of the U.S. government and/or a default in the payment of U.S. Treasury securities could well have very serious economic consequences not only in the U.S. but around the world. It would signal that wide systemic risk exists in the entire world’s economy, which could adversely affect interest rates generally, if not worse.
What happens then if the Fed repeatedly finances bigger and bigger deficits. Naturally here, it must be emphasized that one could engage in endless debate as to how much is big and how much is ruinously big. But putting that important question aside, one can say that as the Fed finances, by increasing the money supply ( a process known as monetizing the debt) bigger and bigger deficits ultimately potential inflation is affected (the risk of higher inflation increases), especially if the economy is at or near actual full employment.
And because banks and bondholder’s must earn interest at a rate that exceeds the inflation rate, a high level of inflation ultimately also means higher interest rates, which negatively affects the willingness of consumers to get mortgages or take out car loans. And, businesses won’t want to invest in new plant and equipment.
But here’s the major point of this piece. For some reason, despite the fact that unemployment is less than 5 percent, and has been for some time, and despite the fact that we have huge federal budget deficits, there has not yet been any significant inflation which would ordinarily also cause a rise
in interest rates.
Put aside here the effect of the further complication of China trade negotiations and tit for tat tariffs
which should cause prices to rise perhaps those price increases are ….so far at least….less noticeable than they would be because net exports minus net imports the last component of GDP (see the fiscal policy video) account for only 7 or 8 percent of the total GDP figure.
But back to the main point, something is amiss.
Our prior videos have pretty much presented standard (Keynesian usually) economic thought.
But there seems to be something wrong with either the location or the shape of the elbow in our AS curve.
Maybe the employment figures being released by the government are inaccurate; or that the unemployment rate is actually higher than 5 percent (or that a lot of the employed are only working part-time or are underemployed). In other words, that the AD curve crosses the AS curve along the more flat portion of the AS curve to the left of the correct elbow in the as curve (that is, before the AS curve starts to rise).
Or, that 5 percent isn’t the real meaningful and “useful” and “relevant”full employment figure to use as the beginning of the elbow. Again meaning that aggregate demand curve crosses the as curve along the more flat portion of the as curve to the left of the correct elbow in the as curve before the as curve starts to rise.
Or, perhaps the shape of the elbow in the as curve is different than we imagined. Perhaps after the correct full employement figure, whatever it is, the elbow doesn’t rise up as dramatically
(meaning prices don’t rise so quickly) as previously suspected.
What could cause these problematic phenomena to our more traditional analysis? in other words, what is holding inflation in check despite all we previously thought about macroeconomic monetary and fiscal policy.
Consider one or all of the following possible explanations:
.1 Technological improvements that change/improve at a faster and faster rate
.2. Immigration, at its current high levels increase the supply of usually cheap labor which tends to hold down prices.
.3. The increasing amount of international trade in a world economy (including the internet) makes existing prices stickier (that, is less likely to increase) because of the existence of increasing competition from overseas alternative sellers and other providers of goods and service.
.4. the slow “velocity” of the existing money through the economy.
Let’s consider these possibilities one by one:
- Technological Change
Technology that changes and improves at a faster and faster rate may well be a major factor in disrupting what we will refer to as the “ 5 percent unemployment/inflation hypothesis” (or, “5UIH”). it may simply be that the elbow in in the AS curve is shifting and will continue to shift (probably at faster and faster rates) to the right as technology makes existing workers more productive on a “per worker” basis. This would mean that fewer and fewer workers can produce the same amount of total goods and services. This leaves more workers on the sidelines who would otherwise be able to contribute more to total economic output, or a higher GDP.
And so, unfortunately for some, in the modern era, technological advances will probably continue to shift the elbow further and further right because fewer and fewer workers can produce more and more—which unfortunately, if not addressed somehow, could result in higher and higher numbers of structurally unemployed and/or underemployed workers.
- immigration and mobile international workforce
Forgive some generalizations here. However, immigrants who move into a country, whether legally or illegally often provide the cheapest source of labor. Not only do they allow employers to produce goods more cheaply, at prices that can be passed on to customer—which has the effect of keeping inflation down– but they also are a source of “unaccounted for” labor which…especially if we are talking about illegal immigrants…distorts what the actual number of unemployed is and/or they make the “5UIH” figure meaningless in determining what the level of unemployment is before the as curve (and thus price levels) rise dramatically.
- The Internet and World Trade Make Prices Stickier
It should be increasingly apparent to everyone that the peoples and economies of world are increasingly interconnected. it is easier and easier to communicate/transmit and find additional sellers and buyers and to shop for better prices on the internet and elsewhere. There is, as a result, more competition. The fact that people in different countries can go “on-line” and buy things…sometimes from different countries…means that sellers in one country have to take into account foreign competitors. And, if their prices get too high, buyers have an increasing number of options to buy elsewhere–often elsewhere in the world. All of this is not to mention the significant effect that “outsourcing” or the risk of outsourcing has on keeping wage costs in line. So, despite the risk international trade presents to some holding domestic jobs, it seems clear that world trade helps to keep inflation in check and prices down.
- The “Velocity” of the Money Supply
This is a subject that would require its own video—hopefully to come—or at least a separate article.)
However, briefly, the low level of inflation, low returns on fixed income investments and perhaps uncertainty all affect where we are in the business cycle. In this regard, perhaps there is a perceived risk of an economic downturn because of the great length of the current period of economic growth. This as well as other factors (perhaps the slow rate of corporate profits remittances from overseas) has reduced the velocity (or speed) with which money is traveling through the economic system. In short, companies and perhaps people are sitting on more cash than usual, thereby not spending it and reducing the level of aggregate demand. All of which could explain why inflation has been held in check.
On related matters, serious note should also be taken of an inverted yield curve (if it hasn’t already occurred as we write this). An inverted yield curve would signal a possible recession. (An inverted yield curve occurs when short term interest rates become higher than long term interest rates.) And, perhaps more alarming, former Federal Reserve Bank Chairman Alan Greenspan has opined that there’s “nothing stopping” negative interest rates from becoming a reality. This raises the question: Is actual deflations (lower general price levels) a significant possibility?
While deflation may sound good to some at first blush, this is almost an alternate universe scenario, intellectually exciting…but it seems ominous, if not outright dangerous in its potential consequences. Again, that’s another article, but it’s one that we frankly hope not to write.
Our hope is to update the videos on the above subject(s). But one has to wonder, given the rapid change in the structure of a world economy and the rapid increase in productivity brought on by quickly changing technology, whether is it possible or even worth it to determine whether an “elbow” exists in the AS curve? And, one has to question whether there really is an elbow in AS unless somehow one has to take into account the potential aggregate supply of the entire world and not just the United States? Perhaps what can be said is that holding technology, the size of the world market, communication and velocity all constant, and, assuming that one can get accurate data, that the elbow model has legitimacy. That is to say that perhaps we can assume that, at or near full employment in fact, (at whatever level full employment actually is), and holding the other factors constant mentioned above, that increasing the money supply would be inflationary. But apparently one or more of the other factors listed above has been shifting and for quite some time.
Perhaps the above is why, the Fed now focuses more on the level of interest rates and inflation than on employment levels in determining monetary policy.
Thanks for your patience.
David D. Lentz
August 16, 2019, updated August 18, 2019
Addendum August 27, 2019
Other possible reasons for the lack of inflation is/are:
- A low or decreasing money multiplier.
- A build up of “excess reserves” at the Fed. Banks are not lending out a substantial portion of their excess reserves at that Federal Reserve. This is due to a significant extent to the 2008 introduction of the IOER rate and the ON RRP (the overnight repo rate the Fed pays to non-banks on reverse repos) rate. Since 2008, the Fed can pay interest at the IOER (the interest rate on excess reserves) to banks on their overnight reserves parked at the Fed. Utilization of the IOER and the ON RRP is how the Fed now controls the Federal Funds rate (which is the rate banks charge each other on loans between banks to meet Federal Reserve “reserve” requirements. The IOER represents the ceiling of the target range of the Federal Funds rate, while the ON RRP represents the floor of that range. The IOER and ON RRP mechanism allows the Fed to manage interest rates without necessarily affecting the size of the reserves it holds.
The down and upside of this is that Banks appear to be choosing to leave their money at the Fed instead of lending it out. If so, that makes banks safer, but it also means that those excess reserve moneys do not get loaned out to companies and people who potentially want to borrow funds either for investment or consumer loan purposes. However, and probably more importantly, this also means that even though the Federal Reserve has created a great “monetary base” since the financial meltdown of 2008, ( to the tune of over $4 trillion), that that money is not making its way into the actual money supply, which if it did would very probably drown the economy with highly inflationary dollars.
© Copyright 2019. David Dixon Lentz. all rights reserved.