Note to Fed: The Phillips Curve Has Left the Building

Note to Fed: The Phillips Curve Has Left the Building

The Phillips curve, which charts an inverse relationship between unemployment and inflation, was proven unreliable during the 1973-1975 recession, when we had stagflation — the combination of high unemployment and rising inflation.

In recent years, to our benefit, we’ve had the opposite — low unemployment and low inflation — which offers further evidence that the Phillips curve is, at best, an outdated model.

Most first-year economics students recognize that the Phillips curve doesn’t work. So why are the Federal Reserve Board and other central banks still relying on this unreliable metric?

Certainly, the lack of correlation between the unemployment rate and inflation (as well as wages) has been apparent in recent years, as the Fed’s attempt to boost the rate of inflation to 2% faltered for years even as unemployment continued to drop.

Like a Broken Clock

Even former central banker Alan Blinder, now an economics professor at Princeton, wrote in The Wall Street Journal, “Since 2000, the correlation between unemployment and changes in inflation is nearly zero. On average, inflation has barely moved as unemployment rose and fell.”

Blinder added that, “The Fed needs to know whether the Phillips curve has died or has just taken an extended vacation.”

While some would argue that the curve proved accurate for a time again in the 1990s, it’s likely a case of the broken clock being accurate twice a day, as a Journal letter writer noted.

So why is the curve passé?

One reason is that the world has changed. Inflation has been low in recent years, in spite of low unemployment, because of technological advances. The Internet made the economy more global, so that there is greater competition, leading to lower prices.

The Internet also made the economy more efficient. Many purchases today are made directly from the producer or an online retailer. The cost is lower, because fewer parties and less labor are involved to complete a sale.

Technology has kept prices lower in other areas, as well. Fracking, for example, created a major increase in the supply of oil and natural gas that has kept energy prices lower in recent years.

The Fed and other central bankers were freaked out about the potential for deflation, which became a significant threat in Europe, but consumers obviously prefer the inflation rate to be near zero rather than rise to the arbitrary 2% goal set by the Fed.

Equations created and used by academics and economists don’t take technological changes into account.

Another reason the Phillips curve doesn’t work is that the unemployment rate is inaccurate. As we’ve repeatedly pointed out, the U-3 rate, which doesn’t include people who have given up looking for work as being unemployed, is inaccurate. True measures of unemployment, including the U-6 rate and the labor force participation rate, show that the level of unemployment, although historically low, is higher than the U-3 rate indicates.

Then there are the economic distortions caused by the Fed’s historically unprecedented accommodative policies caused by quantitative easing. Distortions will continue as the Fed winds down its $4.5 trillion portfolio.

Who Needs the Fed?

There are plenty of economists and journalists arguing that the Phillips curve is not dead, just as there are many Elvis fans who argue that the rock icon is still alive. The Fed, through its Dallas bank, offers wonky excuses for the curve’s failings, but common sense should prevail over economic formulas.

If the Phillips curve hasn’t worked consistently for four decades, it shouldn’t be used by the Fed to help determine economic policy. Academic papers aside, it should be clear that the Phillips curve, like Elvis, has left the building.

It’s one more reason we should let markets, rather than the Fed, determine what interest rates should be. A freer economy that is not subject to wrong-headed decisions, political manipulation and other factors would be a stronger economy.

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