Saturday, July 13, 2019

The Fed chairman says the relationship between inflation and unemployment is gone

By Yuni Li of CNBC.
"Federal Reserve Chairman Jerome Powell said the relationship between unemployment and inflation has collapsed.

“The relationship between the slack in the economy or unemployment and inflation was a strong one 50 years ago ... and has gone away,” Powell said Thursday during his testimony before the Senate Banking Committee. He added the strong tie between unemployment and inflation was broken at least 20 years ago and the relationship “has become weaker and weaker and weaker.”

“In additional to that, we are learning that the neutral interest rate is lower than we had thought and ... the natural rate of unemployment rate is lower than we thought. So monetary policy hasn’t been as accommodative as we had thought,” Powell said.

Under the Fed’s dual mandate of full employment and price stability, the jobless rate has been historically low, inching up to 3.7% in June from 3.6% in May, which was the lowest since 1969. Inflation, however, has been tame in recent years and consistently below the Fed’s 2% target.

The so-called Phillips curve, which the Fed relies on in guiding its policy direction, argues that as unemployment declines, inflation should rise, a phenomenon that has not occurred during this economic expansion.

“At the end of the day, there has to be a connection because low employment will drive wages up and ultimately higher wages will drive inflation, but we haven’t reached that point. In many cases, that connection between the two is quite small these days,” the Fed chief said."
This graph might help

The more money in the economy, or the lower the interest rate, the more demand for all goods and services, holding all other factors constant (this total demand is called aggregate demand or AD). The price level in the economy and the total output or quantity produced in the economy is determined by the interaction of AD and aggregate supply (in this case I am interested in something called short-run AS or SRAS-so yes there is a long-run AS but that is not the important issue here although in the long run we will come back to QF with even more inflation if we go past it in the short run). 

The full-employment GDP (QF in the graph below) is the level of GDP that gives us the natural rate of unemployment. If we move from AD1 to AD2, we will still have very small price increases while having a big increase in GDP which will help lower the unemployment rate. But if we go past AD2 (if interest rates get too low), then we get much bigger price increases than for AD increases to the left of QF. So we want the Fed to set interest rates so that we are at AD2. But no one knows for sure if we are at AD2 or not.

Related posts:

Unemployment Isn’t What It Used to Be: The low rate doesn’t take account of low labor-force participation. Wages are a better indication of slack
The Phillips curve is alive and well (unless it's dead)

Fed officials disagree on how much inflation the current low unemployment rate might cause 

Fed Looks for Goldilocks Path as Jobless Rate Drops