The Fed And The Phillips Curve

By | October 25, 2015

How will the Fed’s dual mandate of stable prices and maximum employment affect the future direction of interest rates!

If and when an important macroeconomic Federal Reserve indicator fails to be relevant but that fact is not fully recognized by the Fed, how will decisions concerning interest rates based on that failed data input impact the real world?

Back at the beginning of September, a period of time when the question of will the Fed or won’t the Fed raise interest rates was front and center, I had written an article titled ‘U.S. Business In The Hands Of Federal Reserve Academicians!‘.

This article in effect questioned whether a group of learned economists, heavy in economic theory but perhaps a tad bit light in real world experience, would have the ability to make the hard decisions that would most certainly have global financial market impact?

The article opened with ‘What is it that can and often will separate successful businessmen and investors from those who may not be? Often it’s the ability to ‘pull the trigger’ on decisions that may not be that easy to make…‘ and went on from there.

In the coming week the Fed will once again be meeting to determine whether Fed Funds rate will go from 0% to perhaps 0.0025%. They will make this decision amidst an array of economic data released over the past month that can only be termed as conflicting and confusing when trying to ascertain the actual condition of the U.S. economy.

The financial markets ‘experts’ and business news pundits are all seemingly of the opinion that any move on rates will now occur sometime in 2016, if then. We will know in a few days whether or not they are correct!

And when the Fed meets, one of the key indicators they will consider when coming to a decision is the Phillips curve, an economic theory that states the following:

When joblessness is low, employers have to pay ever higher wages to attract workers, which feeds through into higher prices more broadly. And inflation is particularly prone to rise when the unemployment rate falls below the “natural rate” at which pretty much everybody who wants a job either has one or can find one quickly.‘ Except it doesn’t work. Or at least, it hasn’t worked very well in the last few decades in the United States. And it has proved particularly problematic to try to use that historical relationship to predict where inflation is going…

Back to the Fed’s mandate…The U.S. economy is at a level that some would term full employment while inflation remains under control so, is the Phillips curve still a relevant and reliable indicator for the Fed heads to use?

From an article at The New York Times titled, ‘The 57-Year-Old Chart That Is Dividing the Fed‘…

Next week, when Federal Reserve officials meet to decide whether to raise interest rates for the first time in nine years, one question will be front and center: How much faith should be placed in a line on a graph first drawn by a New Zealand economist nearly six decades ago, based on data on wages and employment in Britain dating to the 1860s?

That would be the Phillips curve, one of the most important concepts in macroeconomics. It shows how inflation changes when unemployment changes and vice versa. The intuition is simple: When joblessness is low, employers have to pay ever higher wages to attract workers, which feeds through into higher prices more broadly. And inflation is particularly prone to rise when the unemployment rate falls below the “natural rate” at which pretty much everybody who wants a job either has one or can find one quickly.

As the Fed’s chairwoman, Janet L. Yellen, put it in a 2007 speech, the Phillips curve “is a core component of every realistic macroeconomic model…

Read the rest of the article at the NYT here.

Michael Haltman is President of Hallmark Abstract Service in New York.

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