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Fed sticks with Phillips curve despite anemic inflation


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Fed sticks with Phillips curve despite anemic inflation

A model that was supposed to predict the return of higher inflation once joblessness fell to low levels is not working anymore, but the next Federal Reserve chairman does not look like he will drop it as a guide for interest rates any time soon as he insists on continuing to try to boost prices.

The Phillips curve, which posits an inverse relationship between unemployment and inflation, has been relied on for decades by central bankers trying to figure out where to set rates to ensure that the rate of price increases is neither too high nor too low.

Despite unemployment at a 16-year low of 4.1%, the Fed's favored measure of inflation was stuck at 1.4% in October, the same rate as in September, and some distance from the central bank's 2% target. Some members of the Federal Open Market Committee are now openly questioning the usefulness of one of their chief tools, with a number saying at the July meeting that "this framework was not particularly useful in forecasting inflation," minutes showed. Outgoing Fed Chair Janet Yellen has stuck by the Phillips curve as a meaningful model, although she acknowledged in her last press conference Dec. 13 that she was puzzled about why inflation was failing to fire.

So is her replacement. But, while incoming Fed Chair Jerome Powell agreed with Yellen when he told the Senate Banking Committee during his confirmation hearings that it was not clear why prices were not rising faster, he noted that the Fed's credibility depends on continuing to try to push inflation toward 2%. That implies that he would favor holding interest rates lower for longer despite unemployment at such low levels, in the hope that the missing Phillips curve will eventually come out of hiding. He would be unlikely to adopt any alternative guideline for rates — the most prominent of which, the so-called Taylor Rule, uses a number of variables, including inflation as well as the gap between potential and actual economic output.

"Powell does not favor the adoption of a policy rule for the Fed to follow, and we anticipate that he would forcefully argue against the adoption of such a rule," Deutsche Bank Securities Chief Economist Peter Hooper wrote in a note, adding that the incoming chair would likely be alive to the possibility that the Phillips curve has flattened rather than disappeared. "Because these structural changes tend to skew toward a lower inflationary environment, Powell may be less inclined to raise rates in a pre-emptive manner."

Broken model

The last time the Phillips curve was of practically no use to central bankers was in the 1970s, where the exact opposite was happening: high inflation coupled with high unemployment. This dynamic was the result of an energy crisis driving prices higher just as demographic change and other factors pushed up the natural rate of unemployment, according to Peter Ireland, a Boston College economics professor.

What is unprecedented now is the extent to which measures of employment slack, and, therefore, inflation, have been affected by globalization, Claudio Borio, head of the Bank for International Settlements, argued in a recent paper. The entrance of 1.6 billion people from China and the former Soviet bloc to the world economy's effective labor force might have eroded the ability of both workers and firms in places like the U.S. to demand higher prices, he said.

U.S. firms are certainaly reluctant to raise wages, even when having an increasingly tough time finding workers, as FOMC members discussed in their October/November meeting, noting that businesses preferred offering "nonpecuniary" inducements rather than increased pay.

"Assuming something akin to a global Phillips curve, one would expect domestic slack to be an insufficient measure of inflationary or disinflationary pressures; global slack would matter too," Borio wrote.

Technological advances may be of even more concern for inflation going forward. While Borio noted the lack of studies on the issue, he also said their impact in the past "may well have been underestimated and may sometimes be hard to distinguish from that of globalization."

Online retailing, which gives consumers more ability to compare prices, could be knocking off as much as 0.25 percentage points from core goods inflation and 0.10 percentage points from overall core PCE inflation, Goldman Sachs said in a recent research note.

Investor concerns

Others argue that the Phillips curve is still valid, but works better when the economy is in a downturn — not the case now, despite concern from some Fed members about a flattening yield curve. An August research paper by Philadelphia Fed economists found "no evidence for relying on the Phillips curve during normal times, such as those currently facing the U.S. economy."

Maybe, also, the relation between labor markets and inflation is about to reawaken after all. A recent rush into treasury inflation protected securities funds, or TIPS, may mean investors are preparing for rising prices, said Kristina Hooper, Invesco global markets strategist.

In late November there was a $1.2 billion flow into mutual funds and exchange-traded funds focused on TIPS, Hooper said, citing data from Bank of America Merrill Lynch and EPFR Global. The five-year breakeven inflation rate, which measures average inflation expectations in the next five years, is up to 1.77%, according to the St. Louis Fed.

Despite the flattening yield curve, "some investors are suddenly becoming concerned about inflation," she said.