Inflation

Rahul Gandhi Needs a Lesson in Inflation

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Rahul Gandhi, in his new avatar, as the angry young man (yes at 45 he is still young), has a thing or two to say on most issues. Let’s take the latest decision of the Narendra Modi government to cut the interest rates on the public provident fund(PPF) and the small savings schemes like Kisan Vikas Patra(KVP) and National Savings Certificate(NSC). Interest rate cuts ranging from 40 basis points to 130 basis points have been carried out. One basis point is one hundredth of a percentage.

Earlier the interest rates ranged from 8.4% to 9.3%. Now they are in the range of 7.1% to 8.6%. These interest rates come into effect from April 1, 2016.

Rahul Gandhi’s office tweeted to say that “slashing interest rates on small savings – on PPF and KVPs, is yet another assault by the Modi Govt on hard working middle class people.” He further said that “this Govt has failed farmers, failed the poor & now it’s failing the middle class. Modiji ppl are seeing through your event management politics.”

While the Modi government has taken the middle class for granted on other issues, like not passing on the benefits of the fall in oil prices in the form of lower petrol and diesel prices, or trying to tax the Employees’ Provident Fund corpus of private sector employees, the same cannot be said in this case. Before I get into explaining this, we first need to understand the meaning of inflation and how it impacts investment returns.

What is inflation? Inflation is essentially the rate of price increase. If the price of a product in March 2015 is Rs 100 per unit and it jumps to Rs 110 per unit by March 2016, the rate of inflation is said to be 10%. So far so good.

What does it mean when people say inflation  is falling? It doesn’t mean that the prices are falling. It means that the rate of increase in price rise is falling. Allow me to explain. Let’s extend the example considered earlier.

The price of a product in March 2016 is at Rs 110 per unit. Let’s say by March 2017, the price of the product has increased to Rs 115.5 per unit. This means that the price of the product has risen by Rs 5.5 or 5%. The inflation is 5%. Hence, the rate of price rise has fallen and the price of the product has gone up.

A fall in the price of the product would mean the price of the product going below Rs 110 per unit, by March 2017, which is a totally different thing.

This is a very important point which many people don’t understand and hence, it is worth repeating. A fall in the rate of inflation does not mean lower prices, it just means that the rate of price rise is falling or has slowed down.

Now let’s get back to Rahul Gandhi and the Modi government’s decision to cut interest rates on PPF and other small savings schemes.

The rate of interest on offer from April 1 onwards, ranges from 7.1% (on the one-year post office deposit) to 8.6% (on the Senior Citizens Savings Scheme and the Sukanya Samriddhi Account Scheme). What is the prevailing rate of inflation? Inflation as measured by the consumer price index in February 2016 had stood at 5.18%.

What does this tell us? It tells us that the rate of interest on offer on PPF as well as other small savings scheme is higher than the prevailing rate of inflation. This means that the money invested will “actually” grow and not lose its purchasing power. The real rate of return on these schemes is in positive territory. The same cannot be said for the period when Rahul Gandhi’s Congress Party was in power.

Inflation as measured by the consumer price index was 10% or higher between 2008 and 2013. In fact, the inflation during the period stood at an average of 10.1% per year. What was the interest that the Congress led UPA government was paying on PPF and other small savings schemes?

The rate of interest varied from anywhere between 8-9%. This, when the prevailing rate of inflation was greater than 10%. Hence, the money invested in these schemes was actually losing purchasing power.

This is not the case now. Investors are actually earning a “real” return on their investment. Some people told me on the social media that even with lower inflation, prices are not really falling. As I explained earlier, lower inflation does not mean falling prices. It just means that the rate of price increase has slowed down.

Also, it needs to be mentioned here that investments made into PPF and other schemes like Senior Citizens Savings Scheme, National Savings Certificate and Sukanya Samriddhi Account Scheme, enjoy a tax deduction under Section 80C. Hence, the effective rate of return on these schemes is higher than the interest that they pay.

I guess these are points that Rahul Gandhi needs to understand. Editors of media houses who have run headlines saying how the middle class will be hurt because of the cut in interest rates, also need to understand this. While “middle class hurt” makes for a sexy headline, that is really not the case.

Also, it is worth mentioning here that the Modi government is trying to introduce a certain method in the calculation of the interest to be paid on these schemes. The interest will now be linked to the rate of return on government securities and will be calculated every three months.

Indeed, this is a good move and brings a certain transparency to the entire issue. Further, people up until now have been used to interest rates on PPF and small savings schemes remaining unchanged for long periods of time. But now with a quarterly reset in these interest rates coming in, they need to get used to the idea of these interest rates changing on a regular basis.

This is something that needs a change in mental makeup and will happen if the government persists with this. Also, it is important in the days to come the government ensures that the rate of interest being paid on PPF and small savings schemes is higher than the rate of inflation. That to me is the most important thing than the current rate cut.

The column originally appeared in the Vivek Kaul Diary on March 21, 2016

Yellen led Federal Reserve will raise interest rates, but very gradually

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Up until now every time the Federal Open Market Committee has had a meeting, I have maintained that Janet Yellen, the Chairperson of the Federal Reserve of the United States, will not raise interest rates. The latest meeting of the FOMC is currently on (December 15-16, 2015) and I feel that in all probability Janet Yellen and the FOMC will raise the federal funds rate at the end of this meeting.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

So why do I think that the Yellen led FOMC will raise the interest rate now? Two major economic indicators that the FOMC looks at are unemployment and inflation. Price stability and maximum employment is the dual mandate of the Federal Reserve.

There are various ways in which the bureau of labour standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.
U6 is the broadest definition of unemployment and includes work­ers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers,” or people who have stopped looking for work because the economic conditions the way they are make them believe that no work is available for them.

U6 touched a high of 17.2 percent in October 2009, when U3, which is the official unemployment rate, was at 10 percent. Nevertheless, things have improved since then. In October and November 2015, the U3 rate of unemployment stood at 5% of the civilian labour force. The U6 rate of unemployment stood at 9.8% and 9.9% respectively. This is a good improvement since October 2009, six years earlier.

In fact, the gap between U3 and the U6 rate of unemployment has narrowed down considerably. As John Mauldin writes in a research note titled Crime in the Job Report with respect to the unemployment figures of October 2015: “The gap between the two measures [i.e. U3 and U6] is now the smallest in more than seven years, a sign that slack in the labour market is diminishing. And as the Fed weighs a potential rate hike, what may be more important is the number of people working part-time who would prefer to work full-time – that number posted its biggest two-month decline since 1994. Janet Yellen has referred to this number as often as she has to any other specific number. It is on her radar screen.”

In fact, Janet Yellen seems to be feeling reasonably comfortable about the employment numbers. As she said in a speech dated December 2, 2015: “The unemployment rate, which peaked at 10 percent in October 2009, declined to 5 percent in October of this year…The economy has created about 13 million jobs since the low point for employment in early 2010.”

Another indicator that has improved is the number of people who want to work full time but can’t because there are no jobs going around. As Yellen said: “Another margin of labour market slack not reflected in the unemployment rate consists of individuals who report that they are working part time but would prefer a full-time job and cannot find one–those classified as “part time for economic reasons.” The share of such workers jumped from 3 percent of total employment prior to the Great Recession to around 6-1/2 percent by 2010. Since then, however, the share of these part time workers has fallen considerably and now is less than 4 percent of those employed.”

On the flip side what most economists and analysts don’t like to talk about is the fact that the labour force participation rate in the United States has fallen. In November 2015 it stood at 62.5%, against 62.9% a year earlier. It had stood at 66% in September 2008, when the financial crisis started.
Labour force participation rate is essentially the proportion of population which is economically active. A drop in the rate essentially means that over the years Americans have simply dropped out of the workforce having not been able to find a job. Hence, they are not measured in total number of unemployed people and the unemployment numbers improve to that extent.

This negative data point notwithstanding things are looking up a bit. With the U3 unemployment rate down to 5% and U6 down to less than 10%, companies, “in order to entice additional workers, businesses may have to think about paying more money,” writes Mauldin.

And this means wage inflation or the rate at which wages rise, is likely to go up in the days to come. The wage inflation will push up general inflation as well as buoyed by an increase in salaries people are likely buy more goods and services, push up demand and thus push up prices. At least that is how it should play out theoretically.

As Yellen said in a speech earlier this month: “Less progress has been made on the second leg of our dual mandate–price stability–as inflation continues to run below the FOMC’s longer-run objective of 2 percent. Overall consumer price inflation–as measured by the change in the price index for personal consumption expenditures–was only 1/4 percent over the 12 months ending in October.”

But a major reason for low inflation has been a rapid fall in the price of oil over the last one year. How does the inflation number look minus food and energy prices? As Yellen said: “Because food and energy prices are volatile, it is often helpful to look at inflation excluding those two categories–known as core inflation…But core inflation–which ran at 1-1/4 percent over the 12 months ending in October–is also well below our 2 percent objective, partly reflecting the appreciation of the U.S. dollar. The stronger dollar has pushed down the prices of imported goods, placing temporary downward pressure on core inflation.”

In fact, the fall in the price of oil has also brought down the fuel and energy costs of businesses. This has led to a fall in the prices of non-energy items as well. “Taking account of these effects, which may be holding down core inflation by around 1/4 to 1/2 percentage point, it appears that the underlying rate of inflation in the United States has been running in the vicinity of 1-1/2 to 1-3/4 percent,” said Yellen.

In fact, a careful reading of the speech that Yellen made on December 2, clearly tells us that she was setting the ground for raising the federal funds rate when the FOMC met later in the month.

On December 3, 2015, Yellen made a testimony to the Joint Economic Committee of the US Congress. In this testimony she exactly repeated something that she had said a day earlier in the speech. As she said: “That initial rate increase would reflect the Committee’s judgment, based on a range of indicators, that the economy would continue to grow at a pace sufficient to generate further labour market improvement and a return of inflation to 2 percent, even after the reduction in policy accommodation. As I have already noted, I currently judge that U.S. economic growth is likely to be sufficient over the next year or two to result in further improvement in the labour market. Ongoing gains in the labour market, coupled with my judgment that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2 percent as the disinflationary effects of declines in energy and import prices wane.”

This is the closest that a Federal Reserve Chairperson or for that matter any central governor, can come to saying that he or she is ready to raise interest rates. My bet is that the Yellen led FOMC will raise rates at the end of the meeting which is currently on.

Nevertheless, this increase in the federal funds rate will be sugar coated and Yellen is likely to make it very clear that the rate will be raised at a very slow pace. This is primarily because the American economy is still not out of the woods.

The economic recovery remains fragile and heavily dependent on low interest rates. Net exports (exports minus imports) remain weak due to a stronger dollar. Yellen feels that this has subtracted nearly half a percentage point from growth this year.

In this environment economic growth in the United States will be heavily dependent on consumer spending, which in turn will depend on how low interest rates continue to remain. As Yellen said in her recent speech: “Household spending growth has been particularly solid in 2015, with purchases of new motor vehicles especially strong….Increases in home values and stock market prices in recent years, along with reductions in debt, have pushed up the net worth of households, which also supports consumer spending. Finally, interest rates for borrowers remain low, due in part to the FOMC’s accommodative monetary policy, and these low rates appear to have been especially relevant for consumers considering the purchase of durable good.”

This again is a clear indication of the fact that the federal funds rate in particular and interest rates in general will continue to remain low in the years to come.

As Yellen had said in a speech she made in March earlier this year: “However, if conditions do evolve in the manner that most of my FOMC colleagues and I anticipate, I would expect the level of the federal funds rate to be normalized only gradually, reflecting the gradual diminution of headwinds from the financial crisis.”

I expect her to make a statement along similar lines either as a part of the FOMC statement or in the press conference that follows or both.

(The column originally appeared on The Daily Reckoning on December 16, 2015)

Will the 7th Pay Commission recommendations lead to higher inflation?

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The advantage of writing regularly is that one can dwell into great detail on issues of national economic importance. Hence, this is the fourth column on the recommendations of the Seventh Pay Commission this week.

When I started writing regularly in the media nearly 12 years back, the communication with the readers was largely one way. One wrote a piece and then forgot about it. There was no feedback coming in from the readers. There was no way of figuring out whether something one had written had actually been read. If it had been read then what had the readers thought about it?

Some feedback came from the colleagues, if they did read, what one had written (normally they didn’t). The bosses did give feedback once in a while, especially if they didn’t like something one had written.

But now with the advent of the social media, feedback (both good and bad) keeps coming in all the time, and questions keep getting asked. Also, if readers like something they share it. This gives some idea of what the readers are actually interested in. There is constant communication with the readers these days and that’s a good thing.

One of the questions that I recently got asked on Twitter was: “Will the 7th Pay Commission recommendations lead to higher inflation?” As I have mentioned multiple times this week, the Pay Commission recommendations will lead to an increased spending of Rs 1,02,100 crore by the government, to pay higher salaries of central government employees and higher pensions of retired central government employees.

How will this lead to inflation? A part of this increase in salary and pensions will be spent to buy goods and services. As this money chases the same amount of goods and services, prices will go up. This logic seems very straightforward—as straightforward as saying, a cut in interest rates leads to people and companies borrowing more, which is something one hears all the time.

In fact, that is how things played out in the aftermath of the Fifth as well as Sixth Pay Commissions, once their recommendations had been accepted. The higher salaries and pensions led to a higher consumption which led to higher inflation.

As Crisil Research points out in a recent research note 7th Pay Commission: A non-inflationary boost to consumption and investment: “During the Fifth Central Pay Commission(CPC) payout, overall inflation rose by 657 basis points[one basis point is one hundredth of a percentage] on-year in fiscal 1999, while non-food inflation in the same year rose only 141 boints. During the Sixth CPC payout years, however, overall inflation rate rose by 611 basis points on-year between fiscals 2009 and 2010. But this time the increase in non-food inflation was higher and lagged – up 492 bps during fiscals 2010 and 2011.”

So will this phenomenon play out this time around as well? A major reason for inflation the last two times was the fact that the Pay Commission increases came much after they were due. The Sixth Pay Commission increase was due from January 2006. But the report was submitted only in March 2008 and accepted by the government in August 2008. Hence, arrears had to be paid and they were paid only in 2008-2009 and 2009-2010.

This meant that people suddenly ended up with a lot of money in their hands, as payments were made. As Crisil Research points out with regard to the Sixth Pay Commission: “Large arrear payments coincided with the rapid rise in rural wages adding to core inflationary pressures then. These two factors are expected to be absent, this time.”

This time the salary increases are due from January 2016. Unlike the last time, the Pay Commission recommendations have come in before the due date. Also, chances are that the government will implement these recommendations starting from April 2016, the next financial year. Given this, only a limited amount of arrears will have to paid, meaning that people will not suddenly end up with a lot of money in their hands, as they had last time around.

Another factor that needs to be kept in mind is that most factories are not running full steam at this point of time. As Reserve Bank of India governor, Raghuram Rajan, recently pointed out, most factories are running 30% below capacity as of now.

This means that factories can easily ramp up supply if the demand goes up due to higher consumer spending, without leading to higher prices. Typically, if factories are running full steam, a rise in demand cannot be matched immediately with a rise in supply and that leads to prices going up. But that sort of scenario is unlikely to playout as of now.

Over and above this, as and when the recommendations of the Seventh Pay Commission are accepted by the central government, pressure will mount on state governments to increase the salaries and pensions they pay as well. The state government increases won’t happen overnight and will take some time to happen.

And this will allow the inflation due to increased demand, if any, to spread out over a period of time.

As Crisil Research points out: “State governments – which have more employees than the Central government – tend to implement these with a lag. Therefore, while there is a push to consumption demand, it takes place over time allowing supply-side factors to adjust wherever possible.”

The column originally appeared on The Daily Reckoning on Nov 26, 2015

It doesn’t make any sense to hand over your gold to the govt

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The Prime Minister Narendra Modi launched the gold monetisation scheme as well as sovereign gold bonds, yesterday. The scheme and the bonds try to address India’s obsession with gold and the macroeconomic fall out of that obsession.

While nobody really knows how much gold is owned by Indian households, various estimates keep popping up. The estimates that I have seen in the recent past put India’s household gold hoard at 20,000-22,000 tonnes (Don’t ask me how these estimates are arrived at. I have no idea).

In this column I will just concentrate on the gold monetisation scheme and leave the analysis of the sovereign gold bonds for Monday’s column (November 9, 2015). I will also discuss the macroeconmic fall out of India’s obsession with gold on Monday.

The idea behind the gold monetisation scheme is to put India’s idle gold hoard to some use. Under this scheme, you can deposit gold with the bank and earn an interest on it. The Reserve Bank of India (RBI) issued a notification on November 3, 2015, which said that the banks would pay an interest of 2.25% if the gold is deposited for the medium term and 2.5%, if the gold is deposited for the long term. The medium term is a period of five to seven years whereas the long term is a period of 12 to 15 years. (For those interested in knowing the entire process of how to go about it, can click here).

Also, as the RBI notification issued on October 22, 2015, points out: “The designated banks will accept gold deposits under the Short Term (1-3 years) Bank Deposit (STBD) as well as Medium (5-7 years) and Long (12-15 years) Term Government Deposit Schemes. While the former will be accepted by banks on their own account, the latter will be on behalf of Government of India.”

What this means is that individual banks are free to decide on the interest that they will offer on the gold they collect in the short-term for a period of one to three years.

So, the question is will this scheme succeed in getting India’s hoard of gold out from homes and into the banks? The first thing we need to look at is the existing gold deposit scheme which was launched in 1999. The RBI notification issued in October 1999 states that “individual banks will be free to fix the interest rates in tune with their costing considerations. Interest will be payable in cash at fixed intervals or at maturity as decided by the bank.”

Under this scheme the State Bank of India allowed people to deposit gold for three, four or five years. The interest paid on gold was 0.75% for three years and 1% for four and five years, respectively. The minimum deposit had to be 500 hundred grams of gold.

The scheme did not manage to collect much gold. An article in The Financial Express points out: “The existing scheme, introduced 16 years ago, mobilised only 15 tonnes of gold—as the minimum deposit was 500 grams and the interest rate was a mere 0.75% for a three-year deposit.” There was no upper limit to the amount of gold that could be deposited.

As I pointed out earlier in this column, estimates suggest that India has around 20,000 tonnes of gold. When compared to that fifteen tonnes is not even a drop in the ocean.

Further, October 22, 2015 RBI notification on the new gold monetisation scheme clearly states that: “The minimum deposit at any one time shall be raw gold (bars, coins, jewellery excluding stones and other metals) equivalent to 30 grams of gold of 995 fineness. There is no maximum limit for deposit under the scheme.”

So the minimum amount of gold that can be deposited under the new scheme is just 30 grams in comparison to the earlier 500 grams. Over and above this, the gold can be deposited up to a period of 15 years in comparison to the earlier five. Further, the rate of interest on offer is either 2.25% or 2.5%, which is higher than the earlier 0.75-1%.

On all these counts the new gold monetisation scheme is a significant improvement on the gold deposit scheme. Given this, will gold move from Indian homes to banks (and indirectly to the government, given that banks are running a major part of the scheme on behalf of the government)?

Before answering this, it is worth asking here, why do Indians buy gold? It is a part of our tradition and culture is the simple answer. What does that basically mean? It means we buy gold because our ancestors used to buy gold as well. We also buy gold because it is easy to sell during times of emergency. We are emotionally attached to the gold we buy and like seeing it in the physical form. This makes it highly unlikely that the gold monetisation scheme will be a smashing success.

Any more reasons? Gold is a very easy way to hide black money (essentially money which has been earned and on which tax has not been paid). A lot of black money can be stored by buying just a few bars of gold. People who have invested their black money in gold are not going to come forward with it and deposit it in banks. That is really a no-brainer.

Further, the customer agreeing to deposit the gold the bank will “have to fill-up a Bank/KYC form and give his consent for melting the gold.” The gold will be melted in order to test its purity. Also, the “the gold ornament will then be cleaned of its dirt, studs, meena etc.”

The question is how many women would like to see their gold jewellery melted so that they can earn a return of a little more than 2% per year on it? I don’t think I need to answer that question.

These reasons best explain why the gold deposit scheme launched in 1999 has been a huge failure. And they also explain why the current gold monetisation scheme is unlikely to lead to any major shift of gold from homes to the government.

This brings me to the question whether you should be depositing your gold with the banks (and essentially the government)? One reason why people buy gold is because they believe that it acts as a hedge against inflation. The evidence on whether gold acts as a hedge against inflation is not so straightforward.

As John Plender writes in Capitalism—Money, Morals and Markets: “In real terms, the price of gold in 2012 was similar to the prevailing price in 1265.” So doesn’t that mean that gold has acted as a store of value over the last 1000 years? Not really. As Plender writes: “Over much of that time, though, the yellow metal failed to live up to its reputation as a solid store of value.”

Why does Plender say that? Dylan Grice, who used to work for Societe Generale explains this. As Grice writes: “A fifteenth-century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years.”

In fact, even those who had bought gold at the peak of the 1971-1981 bull market in gold would have lost around 80% of their investment in real terms, over the next two decades.

Nevertheless, if you believe that gold acts as a hedge against inflation, should you hand over your gold to the government? Inflation more often than not is due to the “easy money” policies run by the government. This could mean inflation created through money printing or keeping interest rates too low for too long.

When gold and silver were money, the governments destroyed money by debasing it, i.e., lowering the content of precious met­als in the coins they issued.

When paper money replaced precious metals as money, the governments destroyed it by simply printing more and more of it. Now they create money digitally.

So the last thing you should do is hand over gold to the government. The reason you are holding gold is because you don’t trust the government to do a good job of managing the value of money. And given that, it’s best that the hedge (i.e. gold) be with you. If that means losing out on interest of 2.25-2.5% per year, then so be it.

Postscript: On Monday (Nov 9, 2015) I will be analysing the sovereign gold bonds which have been launched as well. Look out for that.

The column originally appeared on The Daily Reckoning on Nov 6, 2015

Phillip’s curve: The economic theory that Janet Yellen is stuck with

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The interest rate setters at the Federal Reserve of the United States, the American central bank, have decided not to raise the federal funds rate, for the time being. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The federal funds rate has been maintained in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. The Federal Reserve has been aiming for an inflation of 2%.

The measure of inflation that the Fed looks at is the core personal consumption expenditure (PCE) deflator. The deflator in July 2015 was at 1.2% in comparison to a year earlier, which is significantly lower than the 2% rate of inflation that the Federal Reserve is aiming for.

The statement released by the Federal Reserve on Sep 17, 2015 said: “Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports…Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability…The Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further.”

Before getting into analysing this statement, I would like to go back into history and talk about something known as the Phillips curve. The Phillips curve was the work of an economist called William Phillips. Phillips was a New Zealander by birth. At the end of the Second World War, he landed at the London School of Economics (LSE).

As Tim Harford writes in The Undercover Economist Strikes Back — How to Run — Or Ruin — An Economy: “As a part of his work on economic dynamics, Phillips gathered data on nominal wages (a good proxy for inflation) and unemployment, and plotted the data on a graph. He found a strong and surprisingly precise empirical relationship between the two; when nominal wages were rising strongly, unemployment would tend to be low. When nominal wages were falling or stagnant, unemployment would be high.”

There was great pressure on Phillips to publish something so that he could be offered a professorial chair at the LSE. As Harford points out: “So Phillips, under pressure from his colleagues to publish something, dusted off his weekend’s work and turned it into a paper. He was unimpressed with his own work, later describing it as ‘a rushed job’. [His] colleagues, ever eager to help his career along, got the paper published in LSE’s journal Economica, under the title ‘The

Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957.’”

The research paper was published in 1958 and “became the most cited academic paper in the history of macroeconomics”. The inverse relationship between unemployment and wages was explained by the fact that during periods of low unemployment, companies would have to offer higher wages in order to attract prospective employees. And higher salaries would mean higher wage inflation.

Over the years, the phrase wage inflation was replaced by simply inflation, even though they are not exactly the same. Hence, during the period of the low unemployment, inflation is high and vice versa, is something that many economists came to believe.

The Phillips curve became extremely popular over the years. As Harford writes: “The reason the ‘Phillips curve’ became so popular is that other economists – notably Paul Samuelson – championed the idea that policymakers could pick a point on the curve to aim for. If they want wanted to reduce unemployment, they’d have to tolerate higher inflation; if they wanted to get inflation down, they’d have to accept higher unemployment.”

But that is not how things always work. Over the last few years, the official rate of unemployment in the United States has come down. As of July 2015 it stood at 5.3% of the total civilian labour force. In July 2014, the number had stood at 6.2%. Even though the unemployment data for August 2015 is available I have considered July 2015 data simply because the inflation data for August 2015 is not available as yet.

What has happened on the inflation front? In July 2015, the core PCE deflator was at 1.2 %. In comparison in July 2014, the core PC deflator was at 1.7%. Hence, what is happening here is the exact opposite of what the Phillips curve predicts.

As official unemployment has fallen, the inflation instead of going up, has fallen as well. Nevertheless, the faith in the Phillips curve still remains high. As Yellen said on Thursday: “We would like to bolster our confidence that inflation will move back to 2%. And of course a further improvement in the labor market does serve that purpose.”

This is nothing but a restatement of the Phillips curve—as the rate of unemployment falls further, the rate of inflation will move towards 2%. The question is will that happen? From the way things have gone up until now, the answer is no.

The Harvard economist Larry Summers in a recent blog explains why the Phillips curve does not work. As he writes: “The Phillips curve is so unstable that it provides little basis for predicting inflation acceleration.  To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.”

Also, if Yellen continues to believe in the Phillips curve, there is no way she can be raising the federal funds rate, any time soon.

Further, the Federal Reserve is now worried about how things are panning out in China as well. As Yellen said: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

What this means is that Yellen feels that China is likely to devalue its currency more in the time to come to fire up its exports. A further devalued yuan will allow Chinese exporters to cut prices of the goods that they export to the United States.

These cheaper imports into the United States are likely to push down the rate of inflation further. This means that the rate of inflation is unlikely to get anywhere near the Federal Reserve’s 2% target anytime soon. Also, it will take time for the Federal Reserve (as well as others operating in the financial markets) to figure out the extent of China’s economic problem. Given this, I don’t see the Federal Reserve raising interest rates, any time soon. At least, not during the course of this year.

In the Daily Reckoning dated March 20, 2015, I had said Janet Yellen’s excuses for not raising interest rates will keep coming. I don’t see that changing anytime soon.

The column originally appeared in The Daily Reckoning on Sep 19, 2015