{"id":3814,"date":"2015-09-19T12:30:11","date_gmt":"2015-09-19T07:00:11","guid":{"rendered":"https:\/\/teekhapan.wordpress.com\/?p=3814"},"modified":"2015-09-19T12:30:11","modified_gmt":"2015-09-19T07:00:11","slug":"phillips-curve-the-economic-theory-that-janet-yellen-is-stuck-with","status":"publish","type":"post","link":"https:\/\/vivekkaul.com\/2015\/09\/19\/phillips-curve-the-economic-theory-that-janet-yellen-is-stuck-with\/","title":{"rendered":"Phillip’s curve: The economic theory that Janet Yellen is stuck with"},"content":{"rendered":"

\"yellen_janet_040512_8x10\"<\/a>
\nThe 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.\u00a0The 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.<\/p>\n

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.\u00a0The Federal Reserve has been aiming for an inflation of 2%.<\/p>\n

The measure of inflation that the Fed looks at is the core\u00a0personal 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.<\/p>\n

The statement released by the Federal Reserve on Sep 17, 2015 said<\/a>: \u201cInflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports\u2026Consistent 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.\u201d<\/p>\n

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).<\/p>\n

As Tim Harford writes in\u00a0The Undercover Economist Strikes Back \u2014 How to Run \u2014 Or Ruin \u2014 An Economy<\/em>: \u201cAs 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<\/em>.\u201d<\/p>\n

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: \u201cSo Phillips, under pressure from his colleagues to publish something, dusted off his weekend\u2019s work and turned it into a paper. He was unimpressed with his own work, later describing it as \u2018a rushed job\u2019. [His] colleagues, ever eager to help his career along, got the paper published in LSE\u2019s journal\u00a0Economica,\u00a0under the title <\/em>\u2018The<\/p>\n

Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957.\u2019<\/em>\u201d<\/p>\n

The research paper was published in 1958 and \u201cbecame the most cited academic paper in the history of macroeconomics\u201d. The inverse relationship between unemployment and wages was explained by the fact that during periods of low unemployment,\u00a0companies would have to offer higher wages in order to attract prospective employees. And higher salaries would mean higher wage inflation.<\/p>\n

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.<\/p>\n

The Phillips curve became extremely popular over the years. As Harford writes: \u201cThe reason the \u2018Phillips curve\u2019 became so popular is that other economists \u2013 notably Paul Samuelson \u2013 championed the idea that policymakers could pick a point on the curve to aim for. If they want wanted to reduce unemployment, they\u2019d have to tolerate higher inflation; if they wanted to get inflation down, they\u2019d have to accept higher unemployment<\/em>.\u201d<\/p>\n

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.<\/p>\n

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.<\/p>\n

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: \u201cWe 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.\u201d<\/p>\n

This is nothing but a restatement of the Phillips curve\u2014as 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.<\/p>\n

The Harvard economist Larry Summers\u00a0in a recent blog explains<\/a>\u00a0why the Phillips curve does not work. As he writes: \u201cThe Phillips curve is so unstable that it provides little basis for predicting inflation acceleration. \u00a0To take just two examples \u2014 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<\/em>.\u201d<\/p>\n

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.<\/p>\n

Further, the Federal Reserve is now worried about how things are panning out in China as well. As Yellen said:\u00a0\u201cThe outlook abroad appears to have become more uncertain of late. And\u2026heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.\u201d<\/p>\n

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.<\/p>\n

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\u2019s 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\u2019s economic problem. Given this, I don\u2019t see the Federal Reserve raising interest rates, any time soon. At least, not during the course of this year.<\/p>\n

In the Daily Reckoning dated March 20, 2015<\/a>, I had said\u00a0Janet Yellen’s excuses for not raising interest rates will keep coming. I don\u2019t see that changing anytime soon.<\/p>\n

The column originally appeared in The Daily Reckoning <\/a>on Sep 19, 2015<\/p>\n","protected":false},"excerpt":{"rendered":"

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.\u00a0The 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 … <\/p>\n

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