Edward Lambert's Recession Equation Warning

This article was first published by me on Talkmarkets: http://www.talkmarkets.com/content/education/edward-lamberts-recession-equation-warning?post=113119&uid=4798

Edward Lambert, who has contributed to the study of effective demand, has produced an equation that indicates recession. The Cobra Equation predicts recession, as profits fall in relation to wage increases. It will be displayed at the end of this article. It results in the chart below, with the red line showing profit rate based on capacity utilization and the yellow chart showing profit rate based on unemployment. They are remarkably similar.

Utilization of capital reached its peak at the end of 2014 as you look at the chart below. The significance of this chart is that the Fed should have attempted to normalize rates while the business cycle was on the upswing, showing the yellow line descending on the chart. By the time the peak of the profit cycle hit in late 2014, the Fed should have normalized rates. Dr. Lambert believes that the Fed does not have the tools he offers to measure the business cycle correctly!

As Dr. Lambert has said:

The utilizations of labor and capital reached profit maximization, slid along the max limit, and have since backed off which is setting the stage for a recession type scenario.
Dr. Lambert talks about Tim Duy and his statement that GDP is falling while the labor market is improving. The chart above and the equation below measure that reality. However, Tim Duy has something else to say that is much like what I have seen from others. He said that interest rates are simply not enough. He believes that the conundrum is still in place and that just focusing on short term rates will fail:

The flattening of the U.S. yield curve as investors see little chance of rates rising in the longer term should serve as a red flag that their focus on short-term interest rates may be doomed to failure.

I have also believed that the Fed simply wants interest rates to remain low on the long end so that more long bonds will be bought and used as collateral, creating more prosperity. The collateral must be protected and the Greenspan conundrum still likely exists based on real bond demand. But clearly, the Fed did miss the business cycle and seeking to raise rates now, according to Dr. Lambert, would make things worse, having missed the cycle. But Tim Duy had more to say regarding flattening of the yield curve:

 If additional rates hikes compress the yield curve further, the capacity for maturity transformation – effectively the process of borrowing on shorter time frames to lend on longer time frames – will soon be compromised.
Federal Reserve Governor Daniel Tarullo says this flattening of the yield curve may destabilize the banking system. Since the article was written, long rates have gone up but are likely range bound.

But it appears that Janet Yellen is listening to SF Fed President John Williams, who says the opposite of Duy and Tarullo, saying that wage growth will kindle inflation and rates need to be raised quickly, and now exacerbated by the Trump reflation, raised immediately. 

If Yellen and Williams are right, they waited too long into the business cycle to raise rates anyway as the following equation and chart above proves. But it could be that they are wrong, and wage growth in the teeth of diminishing profitability will lead to recession and they will just make it worse. For Yellen and Williams, Dr. Lambert's research is crucial input that is being ignored.

Here is Dr. Lambert's equation by permission:
The Cobra EquationThe driving force behind an effective demand limit is the aggregate profit rate. When companies have increasing profit rates, it is more difficult to have a recession. We have seen in the past year that the aggregate profit rate is falling. This is not a good time to be raising interest rates. It would have been better a few years ago. Anyway...I gauge aggregate profit rates in 3-dimensional space with what I call the Cobra equation, because it resembles a cobra in 3-D space...Profit rate = (U + C) - a*(U2 * C2)U = (1 - unemployment rate) C = Capacity utilization a = effective labor share2 - 2.475 * effective labor share + 2When I take the derivative of the equation, I can gauge the potential change of the aggregate profit rates. I can take the derivative with respect to C and U.d profit rate/dC = (1 - 2aCU2)d profit rate/dU = (1 - 2aUC2)


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