Slaves to the misguided Phillips Curve

From a Janet Yellen speech in 2007:

The Phillips curve is a core component of every realistic macroeconomic model. It plays a critical role in policy determination, because its characteristics importantly influence the short- and long-run tradeoffs that central banks face as they strive to achieve price stability and, in the Federal Reserve’s case, maximum sustainable employment—our second, congressionally mandated goal.

In her speech – Labor Market Dynamics and Monetary Policy –at the Jackson Hole gathering she says:

In my remarks this morning, I will review a number of developments related to the functioning of the labor market that have made it more difficult to judge the remaining degree of slack. Differing interpretations of these developments affect judgments concerning the appropriate path of monetary policy. Before turning to the specifics, however, I would like to provide some context concerning the role of the labor market in shaping monetary policy over the past several years. During that time, the FOMC has maintained a highly accommodative monetary policy(!) in pursuit of its congressionally mandated goals of maximum employment and stable prices. The Committee judged such a stance appropriate because inflation has fallen short of our 2 percent objective while the labor market, until recently, operated very far from any reasonable definition of maximum employment.


One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.

The set of charts below shows how unreliable the labor market indicator is for the behavior of inflation and also that monetary policy has been nowhere near accommodative (let alone “highly”). The bottom chart indicates that the NGDP gap has lost all meaning after late 2009 – an indication that the trend level of spending has, in reality, become much lower than previously – implying that the economy is stuck at a depressed level with much lower labor participation rate and level of employment  than otherwise would be the case but also with a below target rate of inflation.





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