Jump In Base Fed Rate Would Continue For July…

By Edward Lambert of Angry Bear
Tuesday, August 19, 2014 11:10 AM EDT

What would the Fed funds rate be as if we were in normal times? Basically, what would the Fed funds rate be if we used a rule instead of the discretionary policy being used by the Fed?

I use my Effective Demand rule using the CPI (less food & energy) data released just this morning. My ED rule has an advantage over other rules that use GDP numbers because they have to wait 3 months for the GDP numbers. I do not. So here is the monthly update of where the Fed’s base nominal interest rate would be as if we were in normal times…

The 3rd quarter of 2014 so far is starting out by reinforcing the jump up in the ED “rule” rate seen in 2nd quarter 2014. The ED rule is giving the same rate of 3.5% for July 2014. Let me show you how this is calculated.

Here is the Effective Demand rule…

Effective Demand Fed Rate Rule = z*(TFUR2 + LSA2) – (1 – z)*(TFUR + LSA) + inflation target + 1.5*(current inflation – inflation target)

z = (2*LSA + NR)/(2*(LSA2 + LSA))

TFUR = Total Factor Utilization Rate, (capacity utilization * (1 – unemployment rate)), 74.3% for July 2014.
LSA = Effective Labor Share Anchor is currently 74.5.
NR = Natural real rate of interest is assumed to be 1.8% currently.)
Inflation target = 2.0%
Current inflation (CPI less food & energy) = 1.855% in July 2014.
1.5 coefficient = To give the Fed rate leverage when inflation gets off target. Fed rate would change 1.5x more than inflation is off target.

We first determine the z coefficient…

z = (2 * 74.5% + 1.8%)/(2*(74.5%2 + 74.5%)) = 58.00%

Then we determine the TFUR for July 2014…

TFUR = 79.2% * (1 – 6.2%) = 74.3%

Now we use the Effective Demand rule to determine the base nominal rate…

58%*(74.3%2 + 74.5%2) – (1 – 58%)*(74.3% + 74.5%) + 2.0% + 1.5*(1.855 – 2.0%) = 3.5%

The ED rule worked very well for decades before the crisis. We get an idea of the twilight zone in which monetary policy now finds itself. The Fed just does not understand the unusual shift in Effective Demand which has occurred in the last decade.

Disclosure: None.

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Moon Kil Woong • 11 years ago • Contributor's comment
The Federal Reserve has become essentially a captured central bank due to their own grousing for power and the ability to dole out liquidity to TBTF banks to keep them in check (it's hard to go bankrupt when you get all the money you want for free). Their zirp rates have nothing to do with economic reality and 100% to do with enriching and supporting State banks called TBTF and pleasing those in political power. Their behavior borders on socialist and their money supply is destroying the real economy even if it doesn't spark sudden inflation. You can't have increasing amounts of bankers getting richer than anyone else producing nothing and refusing to pass on the liquidity to the market. Furthermore, you can't have an economy dependent on artificially low rates and a government dependent on the central bank to buy their own debt at artificially low rates. This is not just a planned economy, but a badly run and broken planned economy that is failing to see and address its real issues. Sadly, at this rate, we are better off without a Federal Reserve than one that has such little regard for capitalism and free market economies. The way we are going they might as well start printing Rubles.