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The Fed and the Phillips Curve

Deflation is the Order of the Day

The Fed was established in December, 1913 after the Panic of 1907 (the latest in a series of financial panics dating back to the middle of the 19th century) put the economy into a severe recession via bank runs and subsequent bank failures.  The Fed’s original purpose was to provide the nation with a safer, more flexible, and more stable monetary and financial system.  Besides providing liquidity to the banking system in times of financial stress, the Fed’s mandate was interpreted to include price stability, the containment of inflation.

The Phillips Curve
In 1958, economist A.W. Phillips observed a century long inverse relationship between wage rates and unemployment in the U.K.  In 1960, noted U.S. economists Samuelson and Solow took Phillips’ original idea and made the link between inflation and unemployment quite specific: when unemployment is low, inflation is high, and vice-versa.  This idea became known as the Phillips Curve; the “curve” shows a strong relationship such that when the historical data are set out on a graph with one axis labelled unemployment and the other inflation, there is a close fit  between low unemployment and high inflation, and vice-versa.  Intuitively, this makes sense: In a stable world where economic growth is occurring but there are few people unemployed, wages rise rapidly as employers bid up the price of the scare labor resource.

The Dual Mandate
However, in the 1970s, just a few years after Samuelson and Solow popularized the Phillips Curve idea, the relationship was no longer working.  A condition known as “stagflation” plagued the economy (high inflation and high unemployment).  As part of the effort to “help” the economy, in November, 1977, Congress amended the original Federal Reserve Act to give the Fed a dual mandate.  Now, not only was the Fed responsible for price stability, but its policies also had to pursue the promotion of maximum employment.  Given this dual mandate, now having to do with both prices and employment, it isn’t any wonder why today’s Fed still clings to the simplistic Phillips Curve idea that these two issues are somehow intimately related.

Phillips Curve Predicts Inflation Soon
As I and others have commented over the course of the last year or so, the Janet Yellen Fed appears convinced that the Phillips Curve is alive and well and that the “low” level of unemployment (4.3% for the U3 series, the lowest level in 16 years) will “soon” (2018 according to Yellen) ignite inflation’s fires and push inflation’s rate to the Fed’s desired 2% level.  Given this thinking, because there is a long lag between the Fed’s actions and their impact on the economy, the right thing to do appears to be to pre-empt inflation running too much above 2% by tightening monetary policy now.  The trouble with this, of course, is that every major indicator of the economy except the unemployment rate shows weakness.

Dumbfounded Economists
As an aside, economists practicing in the 1970s would have been dumbfounded back then by the notion that the price stability (0%-1.5% inflation) that currently exists in the U.S. economy would represent an inflation rate that was “too low.”  After all, until 1977, it was the basic mandate of the Fed to promote price “stability,” i.e., a 0% rate of inflation.  A Fed that tolerated any inflation was not ever considered.

Factors Mitigating the Unemployment/Inflation Relationship
In today’s world, there are many reasons why the inverse unemployment/inflation relationship doesn’t seem to hold:
•    Today’s U3 unemployment measure is not the same as the pre-1990s “unemployment rate.”  Economists have ignored the definitional changes in the official BLS employment data that occurred in the 1990s, and behave as if the data from earlier periods is comparable.   It appears that the U6 definition of unemployment, which includes the marginally employed and those that are part-time because they can’t find full time jobs, is a closer definition to the unemployment rate of the 60s, 70s and 80s than is today’s U3 measure.  If viewed from that perspective, today’s 8.6% U6 unemployment rate would not elicit an expectation that inflation would be anything but tame using the historical Phillips Curve relationships;
•    As I and others have chronicled over the past several months, cracks have been appearing in the U.S economic growth engine.  Slow or no growth is the order of the day.  If that tepid growth better represents economic reality than the 4.3% U3 unemployment rate, then, even if a Phillips Curve type relationship exists in today’s world, we shouldn’t expect a return of significant inflationary pressures;
•    Over the last 50 years, the U.S. has lost much of its manufacturing base (high wage jobs) and has become a service oriented economy (lower wage jobs).  Today’s mix of jobs, not just the sheer number of jobs themselves (U3 counts a part-time job with the same weight as a full-time one) may also be playing an important role in the tepid pace of wage growth.  Economist David Rosenberg has observed that low wage jobs are now a higher proportion of total jobs than pre-recession, and that high wage jobs haven’t grown at all.

We Live in a Deflationary World
The U3 unemployment rate is the only major economic indicator that says the economy is operating at/near its capacity.   The data regarding aging demographics, burdensome debt loads, excess industrial capacity (worldwide) and the impacts of accelerating technology on the workforce all tell us something different.  In the 9th year of recovery, deflation is all pervasive, not inflation as has been the case in the late stages of most post-war recoveries.  A continuation of monetary tightening will only serve to slow growth further and put further downward pressure on inflation.  One needs to look no further for such evidence than the housing industry where sales have slowed significantly with the small rate hikes the Fed has enacted to date.  Since interest rates are closely tied to inflation, it is hard to see them rising anytime soon.

Robert Barone, Ph.D.

Robert Barone, Ph.D. is a Georgetown educated economist.  He is a financial advisor at Fieldstone Financial.  www.FieldstoneFinancial.com .

He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco.  Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee.  Robert leads the investment governance program at Fieldstone Financial and is the head of Fieldstone Research  www.FieldstoneResearch.com

Statistics and other information have been compiled from various sources.  The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information


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