Four years ago, we wrote in this blog about the strict proportionality between the CPI inflation and the actual interest rate defined by the Board of Governors of the Federal Reserve System, R. Briefly, the cumulative interest rate is just the cumulative CPI times 1.4. There are periods when the interest rate deviates from the long term inflation trend, which has been almost linear since 1972. Here, we extend observational dataset and discuss the most probable reason why the FRS actually not controlling inflation by presenting the actual economic force behind price inflation, as we presented in a series of papers [e.g., 1, 2, 3, and 4]. Overall, inflation is a linear lagged function of the change in labor force. The latter is driven by a secular change in the participation rate in labor force (LFPR) together with general increase in working age population. In other words, increasing labor force inflate process and decreasing labor force leads to deflation.
Introducing new data obtained from 2012, we depict in Figure 1the effective rate R divided by a factor of 1.37 (see our previous post for details) and the consumer price inflation. One can see that R lags behind the CPI since 1980, i.e. inflation grows at its own rate and R has to follow up. The idea of interest rate is that a higher R should suppress price inflation when it is high due to the effect expensive money. During deflationary periods with slow economy, low (in some countries negative) R has to channel cheap money into the economic growth. The reaction of inflation is also expected not shortly but with some time lag. The
The cumulative influence of the interest rate should produce a desired effect in the long run and inflation should go in the direction towards acceptable values. Figure 2 displays the cumulative effect, i.e. the cumulative values of the monthly estimates of R and CPI multiplied by 1.37. This is an intriguing plot. In the long run, the R curve fluctuates around the CPI one and returns to it. It is hard to believe that the sign of deviation of R from the 1.37CPI curve affects the behavior of the CPI, which is practically linear. Therefore, the influence of monetary policy is under doubt.
The FRS has tried all means to return the CPI to R without any success and have to return R to the CPI!
We have already described the secular changes in LFPR in 2013, 2014, and 2015. Figure 3 illustrates the evolution of LFPR as measured by the Bureau of Labor Statistics. The LFPR curve is accurately approximated by a simple function: LFPR(t) = 62.7+4.3SIN(2π[t-1978]/T). The period T=74 years and the double amplitude is 8.6, i.e. the largest LFPR change is 8.6%. Currently, the LFPR is strictly in the center of the range and in the middle of the fall from 1996 to 2034.
Our concept is based on the observation that the periods of high inflation are related to accelerated labor force growth. Therefore, we have highlighted the most recent and the next period of accelerated growth as marked red (start) and green (end) vertical lines highlight two periods. These periods of accelerated growth lasts 1/4T =18 years. Figure 4 presents the first and second time LFPR derivatives, which are used to select the accelerated growth, i.e. the period when both derivatives are positive. There is a clear coincidence between the period of two-digit inflation and the peak in the first derivative near 1978. This is one of many facts supporting our concept of inflation. This is not the purpose of this post, however. Here, we compare the FRS decisions on discount rates and the behavior of the LFPR curve.
Figure 5 compares the difference between the R and 1.37CPI in Figure 2 (red curve) and the product of the LFPR’ and LFPR’’, i.e. the curve representing the change in acceleration. The latter curve is shifted by 6 years back in time (phase shift of approximately -30 degrees for period of 74 years). The peaks in the difference curve are well synchronized with the acceleration curve, which is leading by 6 years. In reality, FRS decisions are fully driven by the LFPR. Moreover, the FRS is very slow in understanding status quo.
Now, R and 1.37CPI in Figure 2 coincide. This means that the best R has to be 1.37 of the current CPI, but we all know that R will be retained below this value at least before 2020. We are thinking now on the investment opportunities resulting from the predictable FRS behavior.
Figure 1. The federal funds rate, R, divided by 1.37 and the rate of consumer price inflation, CPI, between 1955 and 2016.
Figure 2. Cumulative values of the curves in Figure 1.
Figure 3. The rate of participation in labor force (LFPR). LFPR is accurately approximated by a simple function: LFPR(t) = 62.7+4.3SIN([t-1978]/T). The period T=74 years. Red (start) and green (end) vertical lines highlight two periods of accelerated growth. The periods of accelerated growth lasts 1/4T =18 years. The next period will start in 2034.
Figure 4. First and second time derivatives of the approximating SIN function.
Figure 5. The difference between the cumulative sum of effective federal funds rate (monthly, not seasonally adjusted) and the cumulative sum of the monthly rate (y/y) of consumer price inflation compared to the acceleration periods in the LFPR.