This has been a fundamental guiding economic theory used by the Fed for decades to set interest rates.
A fundamental relationship of mainstream economic theory at the heart of the Federal Reserve’s strategy for setting interest rates has been a poor guide for policy makers for at least three decades, according to a study by the Philadelphia Fed’s top-ranking economist.
The paper, co-authored by Philadelphia Fed Director of Research Michael Dotsey, shows that forecasting models based on the so-called Phillips curve, which asserts a link between unemployment and inflation, don’t actually help predict inflation.
“Our results indicate that monetary policymakers should at best be very cautious in their reliance on the Phillips curve when gauging inflationary pressures,” Dotsey and Philadelphia Fed economists Shigeru Fujita and Tom Stark wrote.
Their study is timely. Fed officials have been surprised by a deceleration in U.S. inflation over the past several months despite a continued decline in unemployment, the opposite of what the Phillips curve relationship would predict.
The Philadelphia Fed economists found that rising unemployment was sometimes able to help predict lower inflation, but falling unemployment didn’t help predict higher inflation. They noted that was particularly the case during the 1970s and early 1980s when the Fed responded to runaway inflation by raising rates so high that the U.S. economy fell into recession.
“Our evidence may indicate that using the Phillips curve may add value to the monetary policy process during downturns, but the evidence is far from conclusive,” they wrote. “We find no evidence for relying on the Phillips curve during normal times, such as those currently facing the U.S. economy.”
Admitting the Obvious
That report is not surprising at all other than a Fed researcher would finally admit the obvious.
However, the FOMC members will keep using the model, despite the study, and despite the obvious.
Absurd Inflation Discussion
“It is de facto not possible to measure price inflation or a general level of prices. The latter is simply nonsense, it doesn’t exist. Both money and goods are subject to changes in supply and demand, hence there is no yardstick by which the purchasing power of money could be measured. And this is before we get to the fact that adding up and averaging the prices of disparate goods simply makes no logical sense.”
So, not only is the Phillips Curve useless at predicting inflation, one cannot properly measure inflation in the first place.
None of the models the Fed relies on works. Repetitive bubbles are proof enough.
Unemployment vs CPI
Pater Tenebrarum at the Acting Man Blog emailed this chart.
Back in March, Janet Yellen commented: “The Phillips Curve is Alive“.
Since Phillips first derived the Phillips Curve there have been lengthy episodes that are inconsistent with his original findings. Particularly, the late 1970s – when inflation and unemployment went vertical in tandem.
How could it be that both went up at once? Weren’t they mutually exclusive? According to the Phillips Curve this was impossible. Yet it happened all the same. In short, the Phillips Curve is a BS theory.
The fact that Yellen still spews this nonsense is intolerable and insulting. This, among other reasons, is why she is toast. Her four-year appointment is set to end in February 2018. We suspect she won’t make it much past the next Presidential inauguration.
It’s not just the Phillips Curve either. Keynes thought inflation and recession could not happen at the same time. Yet, people still cling to that too. This leads to:
Mike “Mish” Shedlock