Wednesday, May 23, 2018

Has the Fed Flattened the Phillips Curve?

See How the Unfettered Fed Flattened the Phillips Curve: Insulating the central bank from politics made it possible to keep inflation and unemployment low by Neel Kashkari. He is president of the Federal Reserve Bank of Minneapolis.

I have had some recent posts on inflation, unemployment and their tradeoff (The Phillips Curve). After some excerpts, I show a Phillips curve and how, if it is flattened, that reducing the unemployment rate will result in a smaller percentage point increase in the inflation rate.

"Until the early 1980s the Phillips curve predicted price and wage growth with reasonable accuracy, but since then the economy has wandered far from the traditional relationship. Wages and inflation haven’t grown nearly as much as it would predict, given the sinking jobless rate."

"This curve is flatter than it used to be, simply because the Fed has gotten better at managing inflation. When unemployment shot up from 4.6% in 2007 to 10% in 2009, the normal curve predicted deep deflation. But the Fed’s aggressive interventions stabilized core inflation, which never fell below 0.9%."

"On the other hand, the “underlying” Phillips curve represents the intrinsic relationship between inflation and the fundamental supply and demand for labor. Even when the Fed keeps actual inflation in check, inflationary pressures can build, and the underlying Phillips curve might remain steep."

"The underlying Phillips curve began to flatten, or lose its power to forecast inflation, in the mid-1980s, and the trend has continued."

"As market participants have gained confidence that the Fed will make decisions based on economic data rather than short-term political considerations, inflation has become more predictable, and wages and prices have become less subject to short-term changes in employment."

In the graph below, on the steep Phillips curve, if the unemployment rate is 8%, and the inflation rate is 3% (point A), to get the unemployment rate to 4%, the inflation rate would have to rise to 7% (point B). That is a three percentage point increase.

But if the Phillips curve becomes flatter, then getting the unemployment rate to 4% means the inflation rate only has to rise to about 3.5% (point C). That is only a 1.5 percentage point increase.

Related posts

Nobody knows what the natural rate of unemployment is today

More on the natural rate of unemployment

How Central Banks Differ In Their Methods Of Calculating Inflation

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