The Phillips Curve still lurks underneath FED thinking

Minnesota Fed Neel Kaskari published today “Why I dissented”, to explain the reasons for his dissent in the latest FOMC Meeting. His dissent has a dovish slant, but does not differ materially from the consensus view. In short, the relationship between inflation & unemployment, known as the Phillips Curve, is still very much alive in the Fed´s decision-making process:

“I strongly support the new Statement on Longer-Run Goals and Monetary Policy Strategy¹ that the Federal Open Market Committee has adopted. It incorporates the lessons we have learned from the prior recovery and gives the Committee sufficient flexibility to make up for periods of low inflation in order to achieve our dual mandate goals.

However, I voted against the FOMC’s September 16, 2020, policy statement because, while I believe the statement is a positive step forward in putting those lessons into practice, I would have preferred the Committee make a stronger commitment to not raising rates until we were certain to have achieved our dual mandate objectives.

The 2015 tightening cycle

To explain my rationale for seeking stronger forward guidance, I first must review what I learned from the recent tightening cycle that began in 2015. That policy tightening was predicated on the Committee’s view that the labor market was reaching maximum employment and therefore inflation was around the corner.

When I first became an FOMC voter, I dissented against all three of the Committee’s rate hikes in 2017 because, as I wrote then: “We are still coming up short on our inflation target, and the job market continues to strengthen, suggesting that slack remains.” ²

Recently, Governor Brainard commented: “had the changes to monetary policy goals and strategy we made in the new [monetary policy strategy] been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains [to the labor market] would have been greater.” ³

We misread the labor market and, as a result, the tightening cycle that we embarked upon was not optimal to achieving our dual mandate goals of maximum employment and stable prices.”

In recent years, we have repeatedly believed we were at or beyond maximum employment only to be surprised when many more Americans reentered the labor market or chose not to leave, increasing the productive capacity of the economy without causing high inflation. To me, maximum employment is the point at which the labor market is just tight enough to deliver 2 percent inflation in equilibrium.”

The highlighted segments indicate the close connection the Fed, even its more dovish members, see continue to exist between unemployment and inflation.

This is not surprising. In March of this year, Marco Del Negro, from the New York Fed, and coauthors presented a paper for discussion with reference to the New Statement on Longer-Run Goals titled “What´s up with the Phillips Curve:

Inflation has been largely disconnected from business cycle ups and downs over the past 30 years.  This puzzling observation is one more reason why the Federal Reserve should consider adopting a systematic monetary policy strategy that reacts more forcefully to off-target inflation—whether too high or too low.”

In What’s Up with the Phillips Curve?, the authors note that inflation in the United States has remained remarkably stable since 1990, even in the face of pronounced cycles in economic activity.  For example. the unemployment rate has fallen from a 25-year high of 10 percent in 2009 during the Great Recession to near 50-year lows of at or under 4 percent over the past two years.  But U.S. inflation hasn’t responded much to the steep drop in joblessness and remains somewhat short of the Fed’s 2 percent inflation target.

They don´t think monetary policy has been the major factor:

Changes in the conduct of monetary policy appear to have played some role in inflation stability in recent decades, but they cannot be its principal explanation, the authors suggest.

Their leading candidate for the driver of inflation stability is a reduced sensitivity of inflation to cost pressures—such as those associated with wage movements—or, in economic parlance, a decline in the slope of the Phillips curve.  This could be due to many structural forces—such as the increased relevance of global supply chains, heightened international competition, and other effects of globalization.

So, they recommend Average Inflation Targeting (AIT):

A flat Phillips Curve requires the monetary authority to work harder to stabilize inflation:  Unemployment needs to get lower to bring inflation back to target after a recession,” the authors write.  They use an econometric model to explore how monetary policy should adapt, examining, for example, a strategy known as average inflation targeting—one of several strategies the Federal Reserve has been evaluating during a public review of its monetary policy framework.

It´s a pity the Fed ignored much better advice, some from people advocating NGDP Level Targeting.

The panel below, covering the post Great Recession “Longest Expansion” provides interesting pointers.

  1. A stable NGDP growth is associated with falling unemployment (and stable inflation)
  2. When NGDP growth falls (below its average growth), unemployment stabilizes (stops falling) and when NGDP growth rises above its average growth, unemployment falls faster.
  3. The Fed´s juggling of the FF rate does not seem to connect to either inflation or unemployment (with unemployment falling “faster” during the period the FF was on the rise). That was more likely because NGDP was growing more.

FOMC members would do well to read and reflect on a recent paper by Alan Cole of the Senate´s Joint Economic Committee titled “A stable monetary policy to connect more americans to work”:

“The best anchor for monetary policy decisions is nominal income or nominal spending—the amount of money people receive or pay out, which more or less equal out economy-wide. Under an ideal monetary regime, spending should not be too scarce (characterized by low investment and employment), but nor should it be too plentiful (characterized by high and increasing inflation).

While this balance may be easier to imagine than to achieve, this report argues that stabilizing general expectations about the level of nominal income or nominal spending in the economy best allows the private sector to value individual goods and services in the context of that anchored expectation, and build long-term contracts with a reasonable degree of certainty. This target could also be understood as steady growth in the money supply, adjusted for the private sector’s ability to circulate that money supply faster or slower.

Bottom Line:

The Fed´s new strategy may just be a tweak on its old strategy in order to “accommodate” a belated realization that the Phillips Curve is (or has become) flat!

Give the Fed a new compass. We´re going in the wrong direction

According to the news:

Friday’s employment report clears the way for the Federal Reserve to raise short-term interest rates by a quarter-percentage point at its Dec. 15-16 policy meeting, ending seven years of near-zero interest rates.

The Fed can reasonably well control nominal spending (NGDP) growth. Stable NGDP growth at the appropriate level well defines what good monetary policy is supposed to look like.

If that´s true, when NGDP growth falters, things like employment growth will register the “punch”, just as it will “blossom” when monetary policy pulls NGDP growth up. Stable NGDP growth goes hand-in-hand with stable employment growth (only thing is if NGDP level falls short, so will the level of employment)

Examples from the mid-1990s and early 2000s show the Greenspan years. For the last ten years, we have been under Bernanke and Yellen. The pictures are illustrative. (The montlhy NGDP numbers come from Macroeconomic Advisers)

Throughout the period, inflation was not a problem. By the mid-1990s, it had reached the “low and stable” target of the time. Ironically, after the numerical 2% target was set in January 2012, inflation has languished, but is still “low and stable”!

Employ Report 11-15_1

Employ Report 11-15_2

But if you zoom in on the past 15 months, things seem “fishy”. For all the Fed´s “communication”, the truth is that they have been tightening policy. NGDP growth is coming down which was shortly followed by decreasing employment growth. Won´t even mention inflation.

Employ Report 11-15_3

To wrap up, where´s the much touted wage growth-inflation nexus so cherished by some at the FOMC?

Employ Report 11-15_4

Great harm might be on the way!

PS If you don´t believe me about the “beauty” of stable nominal spending, believe George Selgin:

a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes.  Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms.

Yellen´s unchanging beliefs

The pity is that they are wrong beliefs! From the September 1996 FOMC:

I believe that a very solid case can also be made for raising the federal funds rate at least modestly, by 25 basis points, on the grounds that the unemployment rate has notched down further, the decline in labor market slack is palpable, and the odds of a rise in the inflation rate have increased, whatever the level of the NAIRU and the associated level of those odds. I believe I am echoing Governor Meyer in saying that I favor a policy approach in which, absent clear contra-indications, our policy instrument would be routinely adjusted in response to changing pressures on resources and movements in actual inflation.

She clearly belongs in the “accelerationist” camp recently defined by Justin Wolfers, where the other camp is the “inflation targeters”, to which Bernanke belonged:

What does this mean for the Fed? It’s too simple to characterize the current debate as one between hawks who dislike inflation and doves who are more concerned about unemployment. Rather, the main divide may be between accelerationists worried that rising wage growth signals an economy at full capacity, versus inflation targeters, who argue that weak wage growth signals that unemployment remains too high. And in the next few weeks, we’ll find out who’s winning that argument.

How did things work out in 1996 and what´s the scenery now?

After Yellen´s “solid case” for a modest rate rise in September 1996, wage growth continued to increase, unemployment continued to fall and so did inflation!

After the July 2014 FOMC Meeting, when it became clear that QE3 was about to close (taper would begin in October), unemployment continued to drop, but notice that wage growth and inflation turned “south”.

Yellens Beliefs

Justin Wolfers post is titled “Is the Economy Overheating? Here’s Why It’s So Hard to Say”. I prefer to ask: Is the Economy Overcooling”?

Friedman and Bernanke agree that interest rates are a bad indicator of the stance of monetary policy (which controls the economy´s “temperature”). It is much better, according to Bernanke, to look at what´s happening to NGDP and inflation.

According to those metrics, in 1996 the economy´s “temperature” was about right, with NGDP growth on a stable path. Now, for the past year, NGDP growth has been falling, indicating that the economy´s “temperature” has been dropping!

By clinging to her “Phillips Curve Faith”, the odds that Yellen´s Fed will make a big mistake in the foreseable future are rising!

Where does Yellen get these crazy ideas – 2

Yellen and other high-ranking members of the FOMC are partial to the following type of statement:

There is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further.

One of those forces is the price of oil.

The charts below show that this particular idea lacks foundation. Between 2004 and 2008, there were two back-to-back oil price shocks. The first from 2004 to 2006 and the second in 2007-2008.

Yellen Crazy Ideas2

What to expect when there is an adverse supply shock like an increase in the price of oil? The dynamic AD-AS model tells us that inflation will tend to rise and real growth to fall. In that situation, the best the Fed can do is to maintain nominal spending (NGDP) growing in a stable manner.

Looking at the left side charts, we see that´s exactly what happened, at least until early 2006. Inflation went up a bit and real growth decreased somewhat, but nominal spending growth remained stable. Bernanke took over the Fed as the first oil shock was ending and immediately (given his inflation targeting “preferences”) allowed NGDP growth to falter.

Soon after, the second oil shock materialized, putting pressure on headline inflation (not shown). NGDP growth continued to fall, magnifying the fall in real growth from the oil shock. We know that after mid-2008 NGDP growth tumbled, being negative for the first time since 1937.

The right hand side of the chart depicts the economy over the last five years, after the worst of the crisis passed. Note that inflation was slowly falling long before the drop in oil price in mid-2014.

Why do they expect inflation to move higher, if they are constraining NGDP growth? They´ll be surprised when real growth (in addition to inflation) falls when oil prices dropped!

An economic impossibility theorem: You cannot have rising inflation without rising NGDP growth!

Where does Yellen get these crazy ideas?

Maybe from her Phillips Curve upbringing. In her Congressional Testimony today, she said:

The U.S. economy is “performing well” and could justify an interest rate hike in December, Federal Reserve Chair Janet Yellen told Congress on Wednesday.

“I see underutilization of labor resources as having diminished significantly,” Yellen said, with inflation expected to rise over the medium term.

The Fed is “expecting the economy will continue to grow at a pace to return inflation to our target over the medium term,” she said. “If the incoming information supports that expectation … December would be a live possibility” for a rate increase, Yellen added.

As James Alexander wrote recently:

The central banks seem to define inflation as inflation two years out, that is, expected inflation based on their own “official” expectations. And, therefore, central bankers are on target with their own targets.

While she expects inflation to rise over the medium term, market based inflation expectations have fallen significantly since July.

Yellen Crazy Ideas_1
Neither does history provide evidence for her “wishes”. The chart shows nominal and real growth and inflation over a five year period following the 1990/91, 2001 and 2008/09 recessions!

Yellen Crazy Ideas_2

Beliefs are to be held forever

And Chairwoman Yellen has forever held the belief that Phillips Curve/NAIRU is the “best inflation indicator”.

In his Final Thoughts on September, Tim Duy writes:

I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.

While a BoG member in 1996, she teamed up with PC/NAIRU other big fan Laurence Meyer:

Dec/96 FOMC Transcript:

L Meyer:

A second justification for policy change would be the conviction that we are already below NAIRU and not likely to move back to it quickly enough to prevent an uptick in inflation. This is basically the staff forecast, and my view has been and continues to be that this is the most serious risk factor in the outlook. Yet, we get stuck in place because we continue to be confronted by the reality of stable to declining core inflation in the face of this prevailing low unemployment rate. So, we wait for additional data to resolve our doubts. The risk of waiting, judging from the modest rise in inflation in the staff forecast, is not very great. Still, it is probably worthwhile noting that in all of the five private-sector forecasts that I looked at, there are increases in core inflation over the next year or two. That is a pervasive tendency that just about everybody is worried about. I think we need to keep that in mind.

J Yellen

To my mind, labor markets are undeniably tight. You remarked last time, Mr. Chairman, that we should be careful not to lull ourselves into a false sense of security about incipient wage pressures by reading too much into that suspiciously low third-quarter ECI, and I agree with that. So, I still feel that we need to avoid complacency about the potential for inflationary pressures to emerge from the labor market down the road.

Sometime later, now as head of President Clinton´s CEA we read:

Yellen CEA  Report 1998

This chapter’s analysis of macroeconomic policy and performance concludes that the economy should continue to grow with low inflation in 1998. The chapter begins with a review of macroeconomic performance and policy in 1997, to show in some detail where the year’s growth came from and how inflation remained so tame. The second section examines the important question of whether our understanding of inflation and our ability to predict it have changed in significant ways. This question is part of a broader inquiry into whether the economy has changed in such fundamental ways that standard analyses of how fast it can grow without inflation need to be replaced with a new view. The conclusion reached here is that no sea change has occurred that would justify ignoring the threat of inflation when the labor market is as tight as it is now;

In a few hours we´ll know if beliefs changed!

Phillips Curve, the FOMC´s Lullaby

Just two days ago, I had something to say on the Fed and the Phillips Curve. Today, Tim Duy concludes, after a lengthy discussion of all the wrong arguments for a rate rise in September:

But if they take that risk, it won’t be because they want to send the markets a message that they are in charge, or that the “Greenspan put” needs to be put to rest, or that they can’t been seen as cowering to the markets, or that they need to stay the course because they already signaled a rate hike, or because foreign central bankers are demanding the Fed hike rates, or because they need to build ammo for the next crisis, or any other reason that comes from barstool moralizing after one too many. If they hike rates it will be for one simple reason: The recent market turmoil does little to shake their faith in the Phillips Curve. That would be the heart of their argument. And if you are arguing for September, that should be the heart of your argument as well.

Phillips Curve LullabyNo matter all the evidence against “Phillips Curvism” that has accumulated over the decades, the FOMC still finds “comfort” in it!