The Fed’s Trade-Off between Inflation and Jobs Is a Myth

The idea that there’s a trade-off between inflation and unemployment seems embedded in the Federal Reserve’s psyche.

The Fed has not increased its benchmark federal funds target rate since 2006. It’s waiting to see if a tighter labor market will push up wages and prices, so the Fed can achieve both full employment and its inflation target of 2%.

The Fed’s adherence to a negatively sloped Phillips curve — predicting lower unemployment obtained by higher inflation — is a flawed model for monetary policy.

Indeed, money doesn’t even enter the analysis, because the implicit assumption is that inflation is caused not by too much money chasing too few goods but by higher wages (caused by a tight labor market) pushing up costs and prices.

It is time to rethink monetary policy and to banish the Phillips curve to the dustbin of history.

The Phillips curve mentality is evident in the following statement by Atlanta Federal Reserve President Dennis Lockhart:

“I think a policymaker has to act on the view that the basic (negative) relationship in the Phillips curve … will assert itself in a reasonable period of time as the economy tightens up.” He finds the logic of the Phillips curve “compelling.”

Most economists would agree that even if unanticipated inflation could reduce unemployment in the short run, any trade-off is tenuous and probably will last no more than a year.

In the longer run, once expectations adjust to reality, the unemployment rate will move toward its natural rate, consistent with market forces — and there will be no permanent trade-off between inflation and unemployment.

Hayek And Friedman Saw It

More important, the stagflation of the 1970s gave credence to the idea that the Phillips curve could be positively sloped with inflation and unemployment moving in the same direction. The positively sloped Phillips curve was foreseen by Nobel laureate economist Friedrich Hayek and anticipated by Milton Friedman in his 1976 Nobel lecture.

In 2002, William Niskanen, a former member of President Reagan’s Council of Economic Advisors, constructed a model to test the Phillips curve’s trade-off hypothesis. He found “no trade-off of unemployment and inflation except in the same year” and “in the long term, the unemployment rate is a positive function of the inflation rate.”

His policy recommendation was that “a monetary policy targeted to achieve a steady growth of aggregate demand at a zero inflation rate is also consistent with the lowest possible sustainable unemployment rate.”

If monetary policy is trapped by a false Phillips curve and by a naive belief in cost-push inflation, then the Fed risks significant forecast errors and misguided monetary policy.

With competitive labor markets and zero inflation, increases in productivity lead to higher real wages.

Meanwhile, excess growth of the quantity of money, engineered by the Fed, will lead to inflation and to higher nominal wages, but not to a permanent drop in the rate of unemployment or to a higher standard of living.

Indeed, variable and high inflation is apt to lead to higher unemployment, as it did in the 1970s.

Volcker Weighs In

When Fed Chairman Paul Volcker fought high inflation, he rejected outright the false short-run Phillips curve mentality. In 1981, he warned the Senate Committee on Banking, Housing and Urban Affairs:

“We will not be successful … in pursuing a full employment policy unless we take care of the inflation side of the equation. … I don’t think that we have the choice in current circumstances — the old trade-off analysis — of buying full employment with a little more inflation. We found out that doesn’t work.”

After six years of Fed stimulus, the growth of labor productivity is far below its long-term average, and economic growth is still sluggish. The U.S. needs to look beyond the Fed to create full employment and sustainable economic growth.

The loss of economic freedom — due to increased regulation, higher taxes and restrictions on trade — needs to be addressed along with the Fed’s increased powers following the 2008 financial crisis.

The Fed’s macro-prudential policy and its payment of interest on reserves are plugging up the monetary pipeline. Banks are not lending out the massive reserves that the Fed created out of thin air. The monetary transmission mechanism is broke.

That’s why inflation remains low. Yet with ultralow interest rates, the Fed has engineered asset bubbles in the bond and stock markets. When rates start to increase, as they must, those bubbles will begin to deflate.

It is time to rethink monetary policy and to banish the Phillips curve to the dustbin of history. To that end, the passage of the Centennial Monetary Commission Act of 2015 by the House Financial Services Committee opens the door for Congress to take up the legislation in September.

A bipartisan commission to examine the Fed’s performance and to consider alternatives to pure discretion under a fiat money regime is overdue after more than 100 years.

James A. Dorn is vice president for monetary studies and a senior fellow at the Cato Institute.