The Fed embraces the Phillips Curve to everyone´s chagrin

And on they go in the wrong direction.

In the news conference Wednesday, however, Yellen defended the Fed’s policy of gradual rate hikes as forestalling a situation that could be much more damaging for disadvantaged groups.

“We want to keep the expansion on a sustainable path and avoid the risk that … we find ourselves in a situation where we’ve done nothing, and then need to raise the funds rate so rapidly that we risk a recession,” she said. “But we are attentive to the fact that inflation is running below our 2 percent objective.”

William Dudley, president of the powerful Federal Reserve Bank of New York and a former Goldman Sachs partner, is pushing a dangerous economic idea.

He argued in a speech this week that the Fed is forced to continue raising interest rates lest the US unemployment rate “crash” to unsustainably low levels and boost inflation abruptly.

According to this piece: “Other Times Unemployment Has Been This Low, It Didn’t End Well

There have been only three fleeting periods in the past half-century when the U.S. unemployment rate was as low as it is today.

This would be cause for celebration but for one disturbing fact: in hindsight, each period was associated with boiling excesses that led to serious economic trouble.

Low unemployment of the late 1960s preceded an inflation spiral in the 1970s. The late 1990s bred the Dot-com bubble and bust. The mid-2000s saw the buildup and collapse of U.S. housing.

While there is reason to believe today’s economy isn’t boiling over as in the past, those episodes call for caution.

“It’s not a matter of superstition, it’s a matter of being mindful of the history of what such a low unemployment rate usually is followed by,” said Michael Feroli, chief U.S. economist of J.P. Morgan Chase & Co.

I put forth the following proposition: The “natural” state of the Phillips Curve is flat. In addition, the fact that it is flat does not mean monetary policy is being conducted appropriately.

In his statement, Dudley remembers the 1960s, when inflation increased at a fast pace when unemployment dropped below 4%. What he misses is that the low unemployment rate was not the driver of inflation, but excessively expansionary monetary policy, which makes the Phillips Curve “non-linear”.

In the next decade, monetary policy continued to be excessively expansionary but we witnessed a shifting Phillips Curve. That´s Friedman´s “Expectations Augmented Phillips Curve” in action!

Later, monetary policy became appropriate, with NGDP growing at a stable rate along a trend level path. The Phillips Curve is flat, and remains flat in the aftermath of the Great Recession. In both instances, monetary policy was not expansionary. In 1994 – 2005, it was appropriate. In 2007 – 2017 it has remained excessively tight.


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