For some at the FOMC, it´s all about the “unemployment theory of inflation”

As reported:

Officials say they remain confident such low unemployment will be enough to lift inflation toward their 2% target in coming years, meeting the Fed’s twin objectives of stable prices and maximum, sustainable employment.

There are, however, exceptions. One is Bullard:

  • The U.S. unemployment rate declined to 4.4 percent in the April reading.
  • Does this mean that U.S. inflation is about to increase substantially?
  • The short answer is no, based on current estimates of the relationship between unemployment and inflation.

Another is Lael Brainard, albeit more tentatively:

I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing. If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.

John Williams is squarely in the “unemployment theory of inflation” camp:

When you look at how the data relate to those two big goals I mentioned—maximum employment and price stability—they paint a very clear picture: The U.S. economy has fully recovered from the global financial crisis and the ensuing recession. In fact, the U.S. economy is about as close to the Fed’s dual mandate goals as we’ve ever been.

When it comes to employment, economists generally view the natural rate of unemployment in the U.S.—by this I mean the level consistent with an economy that is running neither too hot nor too cold—as somewhere in between 4¾ percent and 5 percent.

Today, the U.S. unemployment rate is 4.4 percent—meaning that we’ve reached and even exceeded the full employment mark.

Meanwhile, although inflation has been running somewhat below the Fed’s goal of 2 percent, with the economy doing well and some of the factors that have held inflation down waning, I expect we’ll reach that goal by next year.

Bullard is light years ahead of Williams, and Brainard is moving in the right direction. What is the evidence?

The panel below correlates unemployment and inflation for several periods during the past 60 years.

The only time that anything like a Phillips Curve may be observed is during the 1960s. When the unemployment rate falls below 5% (actually 4.0%) in the latter part of the decade, inflation starts to rise.

During the 1970s, the “Great Inflation” decade, part of the time inflation and unemployment go up together. Go-stop monetary policy results in a “closed loop” after the first oil shock in late 1973.

We then come to the “Volcker Transition” in the first part of the 1980s. First, the fall in inflation is associated with a rise in unemployment. When Fed credibility (no more “go-stop” monetary policy) is established, the “loop” is broken and both inflation and unemployment come down.

During the “Great Moderation” from 1987 to 2005, the curve shifts down and becomes quite flat, with low and stable inflation being consistent with a wide range of unemployment, from less than 4% to more than 6%.

In the more recent period (“Great Recession” followed by a “Long Depression”), the curve is very flat, with inflation being “too low” and stable for a very wide range of unemployment, 4.4% to 10%!

It appears that Bullard´s conclusion is right!

Yellen, who took the helm at the Fed in February 2014, is a “die hard” Phillips Curver. In 1996/97, while a Fed Board Member, she constantly bugged Greenspan to tighten monetary policy because unemployment was “dangerously low”.

Since she took over, the economy has weakened. NGDP growth and RGDP growth came down.

Long-term Yields fell.

As did inflation expectations.

With market expectations worsening, in mid-2016 the Fed “relaxed” monetary policy. It appears that was what brought out what came to be known as the “Trump Bounce”. The March FOMC Meeting, however, seems to have thrown a bucket of cold water, with market indicators moving back down.

As Bullard notes:

This may suggest that the FOMC’s contemplated policy rate path is overly aggressive relative to actual incoming data on U.S. macroeconomic performance.

The recent behavior of consumer spending is not a good omen for growth outcomes going forward. If the Fed raises the Fed Funds rate, as widely anticipated, in the June Meeting, expect economic forecasts to be revised down.

Bottom Line: The month of May likely defines a watershed, with the outlook for the economy “darkening” again.


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