If the Fed Was Your Doctor, You’d Fire Them

Imagine going to the doctor with a major problem. After the exam, the doctor says, “I read this paper published in 1958 and rely that on for all my diagnoses. So, here’s what we need to do.”

If that was me, I’d look for a new doctor. If was a member of the Federal Reserve or another central bank, they’d be happy with someone who thinks like they do.

The Phillips Curve Drives Economic Policy

The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957 is a paper written by William Phillips in 1958 titled, which was published in the quarterly journal Economica. [1]

The paper, “describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow took Phillips’ work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice versa.”

This idea now drives central bank policy.

CNBC recently noted, “Federal Reserve policymakers have been watching the wage situation closely as they ponder why inflation has remained so low during the longest economic expansion in U.S. history and record-low unemployment rates.

Central bankers follow the Phillips Curve, which indicates that low unemployment generally pushes wages higher. Some economists question whether the curve is still valid considering the trend in recent year.” [2]

It is a good idea, but it might need to be updated. First, let’s look at how the idea has worked in the long run. The chart below shows the unemployment rate (the blue line) and the rate of inflation (the red line). Inflation is linked to wage growth and should be a good measure of the applicability of the Phillips Curve.

Prior to 1990, the Phillips Curve does seem to hold.  As unemployment rose, inflation tended to drop. That was the time that globalization increased and the ability to secure cheap labor in global markets seemed to depress the rate of inflation.

In recent years, economists have believed inflation will move towards a higher level as unemployment dropped. With unemployment at fifty-year lows, inflation remains stubbornly low. This has led some economists to question the validity of the Phillips Curve.

A Fresh Look at Unemployment

Unemployment is generally viewed as the number of persons looking for work. Low unemployment is considered to be inflationary since employers will have to raise wages to hire workers when the number of job seekers declines.

The critical level is known as NAIRU, or the non-accelerating inflation rate of unemployment, which is the theoretical level of unemployment below which inflation would be expected to rise.

The Fed’s current estimate of NAIRU is about 4.6%, about 1% higher than the current unemployment rate of 3.6%. But there are other measures of unemployment. The next chart includes one of those alternative measures.

In this chart, the unemployment rate is shown as the gold line and NAIRU is the red line. The data only goes back to 1994 because that is when the alternative measure of unemployment became available.

The blue line is a measure known as U-6 and includes the percentage including the “total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force.

Persons marginally attached to the labor force are those who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the past 12 months.

Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not currently looking for work. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.” [5]

This could be a better measure of the Phillips Curve’s unemployment. While both measures move in the same direction, U-6 is above NAIRU and unemployment is not inflationary until U-6 becomes too low.

This interpretation of the Phillips Curve is consistent with the current economy and shows there might not be a reason to worry about inflation for quite some time.

In other words, the current data can be reconciled to the 1958 paper, after some necessary updates are considered.

Regards,

Michael Carr, CMT, CFTe

Editor, Peak Velocity Trader

Sources:

[1]: Phillips Curve — https://en.wikipedia.org/wiki/Phillips_curve#History

[2]: Paychecks are likely to continue to get bigger despite December slowdown, Goldman says — https://www.cnbc.com/2020/01/27/goldman-paychecks-are-likely-to-continue-to-get-bigger-in-2020.html

[3]: Federal Reserve — https://fred.stlouisfed.org/graph/?g=ntX4

[4]: Federal reserve: https://fred.stlouisfed.org/graph/?g=q6KG

[5]: Bureau of Labor Statistics, Alternative Measures of Unemployment — https://www.bls.gov/news.release/empsit.t15.htm