The Phillips Curve Is Dead, Except at the Fed

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The Phillips Curve is the theory that inflation is the result of total demand outstripping total supply at the national level. In a recent speech, Fed vice chairman Donald Kohn said, “A model in the Phillips curve tradition remains at the core of how most academic researchers and policymakers—including this one—think about fluctuations in inflation.” And with government measures of inflation presently higher than what is thought allowable by our central bank, he added that “bringing overall inflation immediately back to the low rate consistent with price stability could be associated with a much higher rate of unemployment for a short time.”

Kohn’s comments are the prevailing view at a Federal Reserve that believes growth of demand is the primary cause of inflation. Indeed, his statements are no different from those offered up by our present Fed chairman, Ben Bernanke.

In a 2003 speech made while he was vice chairman at the Fed, Bernanke spoke about the possibility of future inflation; specifically that “the effective slack in the economy may be less than we now think, and inflationary pressures may emerge more quickly than we currently expect.” In July of 2005, in a Wall Street Journal op-ed written just months before his nomination as Fed chief, Bernanke asserted that there is a “highest level of employment that can be sustained without creating inflationary pressure.” And since taking over as Fed chairman in 2006, Bernanke has regularly characterized inflation as a function of too much growth. Now, with the dollar still at near historical lows versus gold and other foreign currencies, he says inflation will moderate in coming quarters given his view that slower growth ahead will be the fix for pricing pressures.

H.C. Wainwright research has of course shown the opposite; that if anything high historical rates of GDP growth occur alongside low rates of inflation. This commentary will marry the empirical with the anecdotal in arguing that Fed thinking is wrong. Economic growth can in no way be an inflation accelerant.

A globalizing labor market. Probably the best place to start is employment. Ben Bernanke has made it plain that if U.S. unemployment gets too low, inflationary pressure will be the result. At first glance this makes sense. If there’s a labor shortage, employers presumably have to offer higher wages and salaries to existing and prospective workers, and that might theoretically push prices up too.

But given a second pass, Bernanke’s assumptions don’t hold up. First off, the number of prospective workers is hardly static. If demand for workers is rising in such a way that there is wage pressure, workers on the sidelines will be more willing to offer up their services with knowledge that they’ll be compensated more handsomely.

Secondly, rising wage pressures that result from lack of labor supply are a positive market signal rather than a warning sign about inflation. Wage pressures merely tell the sidelined or underutilized worker to relocate to achieve wage gains. In the end, rising wages are moderated by rising labor supply to capture those same wages.

Taking this further, no doubt everyone is aware of the various talking-head economic scaremongers on TV. CNN’s Lou Dobbs, for example, for several years now has used his soapbox to criticize U.S.-based companies that have moved jobs overseas. But “offshoring” is a positive economic trend that allows for greater work specialization and production, and so long as U.S. companies continue to access the abundant supply of labor from around the world, there’s less need to worry about wage pressures here.

To offer up but one example, Beaverton (OR) based Nike has never manufactured any of the products it sells in the United States. When policymakers at the Fed suggest that falling unemployment in the states is inflationary they ignore the fact that U.S. companies employ the world’s labor force in carrying out their operations. That they do calls into question an inflation model that is heavily based on domestic job pressures, or the lack thereof.

We must also remember how Americans increasingly conduct their individual lives. Most no longer transact with a live human being when buying movie and airplane tickets, when filling their cars up with gasoline, or when they go to the bank to deposit or withdraw money. Big-box producers like Wal-Mart and smaller pharmacies such as CVS increasingly offer self-serve checkout lines involving no human contact while shopping.

Forgetting the migratory path of labor, not to mention the certain availability of foreign labor, markets continue to innovate around labor shortages. Unfortunately, when the Fed uses its interest rate mechanism to slow down the economy and wage pressures, it inhibits the process whereby economic actors innovate, and through innovation, enhance the very productivity that attracts more capital.

Economic “slack.” Moving to capacity utilization, or what Bernanke terms the “amount of slack in the economy,” various FOMC press releases since he took over in 2006 have had a variation of the following statement: “While the Fed expects inflation to moderate, a high level of resource utilization has the potential to sustain those [inflationary] pressures.” Fed thinking here is that if the economy really starts growing, there exists the possibility that producers will run out of manufacturing capacity due to excess demand such that prices will rise.

This too might seem reasonable at first in that the supply/demand function is certainly a factor in pricing. But capacity is hardly static either. Instead, it’s very dynamic in the sense that looming capacity shortages serve as a signal for producers that causes them to increase the very capacity that Fed models deem fixed. It’s also true that manufacturers regularly enhance their production techniques to get more out of their existing assets, thereby increasing capacity.

An easy example is to look at the quality of Ford Motor Company’s initial factories in the early 20th century compared to those in operation today. No one would credibly compare the two, and sure enough, one reason the U.S. auto sector presently struggles is that productivity enhancements have made contracts entered into with labor unions very dated in scope. The basic reality is that all manufacturers need less and less in the way of human inputs to create the goods we buy.

Oil refineries are another example. Much is made of the fact that regulations have made it not worth the hassle for oil companies to build more of them. While that’s true, the main reason the number of U.S.-based refineries continues to shrink has to do with more and more output being derived from the existing ones.

Furthermore, we once again can’t ignore that U.S.-based companies of all stripes continue to access world capacity in order to create the finished products that consumers and companies purchase. Boeing is presently building its 787 Dreamliner in six different countries around the world. And while Apple Computer’s iPods and iPhones were designed in the States, the manufacture of both occurs in Asia. When the Fed worries about capacity stateside being the source of inflationary pressures it assumes that our manufacturing capacity is limited to these fifty states. Happily it is not.

Is demand growth inflationary? The prevailing view at the Federal Reserve is that excess demand itself is inflationary. For background, in a 2007 speech at Stanford, Ben Bernanke questioned whether increased worldwide economic integration has actually driven prices lower. While strongly advocating globalization and free trade, Bernanke said “there seems to be little basis for concluding that globalization overall has significantly reduced inflation” and that “indeed, the opposite may be true.”

Bernanke specifically pointed to demand from China and other formerly dormant countries as major contributors to rising energy and commodity prices in recent years. He also cited a study that showed oil prices in 2005 would have been as much as 40 percent lower absent demand from those economically resurgent countries. That the price of oil since 2001 is up roughly 380 percent in dollars versus 160 percent in euros seemingly did not factor into his analysis, and sure enough, the Fed continues to ignore the dollar’s emasculation as a driver of the commodity market price boom.

Can excess demand or supply affect the general price level? No doubt a shortage of iPhones, flat-screen televisions or hotel rooms in New York City would drive up the price of all three and, to some, this would be inflationary. This theory breaks down because it assumes an increase in income. Without that, if demand for certain products is pushing prices up, demand in other areas must be falling, and in the process, driving other prices down.

Prices at the pump for the average individual have tripled in recent years. That means that the same individual would have a great deal less income to demand other products previously accessible. In sum, the net effect of demand-driven inflation is zero. Demand drives up relative (real) prices for specific items but not necessarily money (nominal) prices.

Is supply growth deflationary? Conversely, while still at the Fed, and in testimony before the Joint Economic Committee, Alan Greenspan said the addition of over 100 million educated workers to the global workforce from the former Soviet Union, China, and India would “double the overall supply of labor,” and that this growth in the number of workers would help “to contain inflation” in the future.

Initially, Greenspan’s reasoning perhaps made a lot of sense. Millions of new workers would certainly drive up supply, and that would put downward pressure on prices. But what Greenspan left out is that for the Indians and Chinese, just as for every worker in the world, what they supply becomes their demand.

Laborers trade products for products, so while the influx of new workers would obviously increase the world supply of goods, it would also yield a commensurate increase in the demand for goods. Newly freed workers in Russia, India and China aren’t creating products for us so that they can remain poor. Instead, they produce to enhance their lifestyles in hopes of eventually living like us.

Some might say that workers around the world save more than us, and that due to savings, their demand will not be commensurate with their supply. This makes the false assumption that savings detract from demand. In truth, banks don’t sit on money saved, but rather lend that money to businesses and entrepreneurs possessing labor and product demands themselves. Money saved is also lent out to individuals intent on spending the money immediately.

It’s also said that the influx of cheap goods from overseas has helped to contain U.S. inflation in recent years. While that may be true when we consider the false readings offered up by product-based government measures of inflation, this assumption doesn’t pass muster when it comes to the general price level. More realistically, if the U.S. is inundated with massive amounts of cheap goods from overseas, its consumers now have more money to demand other goods previously unattainable. Or, if they save money previously spent on essentials, that capital will fund the buying power of new labor entering the workforce. Taking nothing away from the life-enhancing wonder of free trade, its net inflationary or disinflationary effect is zero.

The counter-productive effect of Fed anti-inflation policy. Ultimately, Federal Reserve assumptions about the nature of inflation have a major monetary impact. To read FOMC statements about interest rates, the Fed does not raise rates with a stronger dollar specifically in mind, but to reduce “resource utilization” or, in normal parlance, to slow down employment and production so that the economy doesn’t hit its alleged limits. That being the case, Fed actions to cool economic growth work 100% against its efforts to reduce true inflation.

Indeed, even if we assume that capacity and labor utilization are high within the U.S., this, if anything, would put a damper on inflationary pressures. When businesses produce goods for sale, and when workers supply labor, they are implicitly demanding money. So we can say the total amount of goods and labor for sale on any given day constitutes demand for money. Hence, when the economy is growing, dollar liquidity is shrinking. Or, when the economy is losing steam, liquidity is expanding. If resource utilization is subsiding alongside rising unemployment, the signal is that the demand for money has shrunk, or that there’s too much liquidity.

That’s why inflation correlates so well with economic weakness. From 1970 to 1982, the U.S. economy experienced no fewer than four recessions, but the time in question is notable as a highly inflationary era.

Conversely, the economy grew almost without interruption from 1982 to 2000. If we relied on Fed models to divine inflationary pressures, we might have guessed that the ’80s and ’90s were a time of rising consumer prices, and surely skyrocketing commodities prices. Instead, the CPI measure of inflation was 2.7 percent by the end of the millennium (compared to 13 percent in 1979) while gold, the best monetary benchmark of them all, was trading at a modern low of $255/ounce.

The Fed’s Phillips Curve inflation models aren’t just wrong. They rob workers, manufacturers and investors of the necessary market signals that reveal when an economy is growing or contracting. When the Fed seeks to cool economic growth it does nothing to reduce the general price level, but workers sadly miss out on temporary or long-term wage increases that might result from a rising economy. Producers miss out on market signals telling them what to produce more or less of in the future. And investors are forced to make uncertain investment decisions given the knowledge that the Fed seeks to manage the economy rather than simply target the value of the dollar.

The Phillips Curve has zero predictive powers in the area of inflation, but as evidenced by a flat S&P 500 over the last ten years and an uncertain economy at present, continued reliance on this model will serve as a growth retardant.

Adherence to such a model will also further discredit our central bank. It can be hoped that as the Fed’s reputation plummets, the desire held by many for a price rule to stabilize the dollar will catch on. With that, the notion of limits to growth will be buried for good.

John Tamny is editor of RealClearMarkets, Political Economy editor at Forbes, a Senior Fellow in Economics at Reason Foundation, and a senior economic adviser to Toreador Research and Trading ( He's the author of Who Needs the Fed?: What Taylor Swift, Uber and Robots Tell Us About Money, Credit, and Why We Should Abolish America's Central Bank (Encounter Books, 2016), along with Popular Economics: What the Rolling Stones, Downton Abbey, and LeBron James Can Teach You About Economics (Regnery, 2015). 

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