*By Edward Lambert*

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 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.

The model...

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 '90s. 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 at 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.

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, 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 there 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 of 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 5-6% 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... 1970s, anyone?

The high data points from the '70s 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.