Fed Policy and the Phillips Curve:
Given the recent FOMC meetings and Janet Yellen’s speeches and press conferences on the state of the US economy and current monetary policy, I thought it might be helpful to look at her statements in the context of the Phillips Curve. For students of Monetary Policy (including myself), the Philips Curve can be a helpful lens to view the current uncertainty and decisions facing the Federal Reserve.
Many economists argue that the Phillips curve is too simplistic. There are a lot of other factors at play (which the curve overlooks): stick prices and wages, raw materials, labor productivity, business investment, capital to labor investment tradeoff, etc.
Either way, 75% of the discussion in Yellen’s recent press conference revolved around these two variables: unemployment and inflation. The Phillips Curve plots the Fed’s dual mandate of unemployment and price stability (inflation). The real question is how these two factors influence each other (i.e. do they move together?). In many ways, the employment figure (although limited) has been a core-measure for the overall health of the domestic economy.
This chart is sourced from the Federal Reserve Economic Data (FRED). As shown by the formula, there is a negative relationship between unemployment and inflation. Therefore, when the unemployment rate increase (weakening economic activity), demand decreases and the inflation rate decrease. The negative relationship is illustrated in the correlation coefficient [r] = -0.5186.
Coefficient of Determination (R-Squared) measure is .27, so about 27% of the variation in Inflation can be explained by changes in unemployment. This is most likely the impact of wages on inflation (lower unemployment = higher wages = higher inflation). These relationships are tenuous at best, but there is some correlation.
Along these lines, while the employment numbers have been quite positive (the most since the recession), wages are much more important indicator at this time. Yet wage growth has been minimal to non-existent. Bill Gross recently told Bloomberg, “It’s actually the wage number that is critical, and the jobs that takes second seat,” “To get to the 2 percent inflation target that the Fed wants to get to, assuming a 1 percent productivity number, you are going to have to see wages at 3 percent plus. So the Fed is willing to stay put here.”
Once wages start to grow again, the unprecedented amount of liquidity QE2 provided might jump-start inflation again. Another item for us students to remember, inflation is not a bad thing (in fact, without it Monetary Policy is practically ineffective), but the Fed is seeking to maintain just the right amount of inflation, currently at 2%. More discussion to come…
Heidegger is one of my favorite philosophers and I’ve been perplexed by this for so long. I don’t really understand the man who produced “being and time” could have such views.