The Federal Reserve has two legislated mandates: price stability and “maximum employment.” However, it has stated an explicit numerical objective only for its goal of price stability, which it defines as a two percent rate of inflation. A specific objective for labor market conditions remains unknown and, moreover, the mechanism by which the Fed might accomplish both objectives simultaneously has not been disclosed to the public. Nonetheless, speeches and statements from members of the Federal Open Market Committee (FOMC) seem to indicate that the Phillips curve serves as their guide to monetary policy options.
In its simplest terms, the Phillips curve posits an inverse relation between unemployment and the rate of inflation. As the economy weakens, unemployment rises and this “slack” puts downward pressure on prices. And as activity rebounds, slack declines and this is reflected in lower unemployment and upward pressure on prices. The economy also is assumed to have a “natural” rate of unemployment, which is the lowest that can be sustained in the long run without causing inflation to accelerate. From this perspective, whether monetary policy should be eased, tightened, or left unchanged can be gauged by the size of the gap between the reported rate of unemployment and the natural rate.
With regard to recent deliberations of the FOMC, the Committee’s latest statement of goals and strategy identifies 4.9 percent as its median estimate of the “longer-run normal rate of unemployment.” The Fed’s decision to tighten monetary policy in December, when the unemployment rate stood at 5.0 percent, is consistent with the notion that further declines in unemployment would put its objective for two percent inflation at risk. And to the extent that economic activity is described accurately by a tradeoff between unemployment and inflation, this decision was well founded.
For the Phillips curve to be a reliable guide for monetary policy decisions, however, at least two conditions must be met. First, the tradeoff between unemployment and inflation must not only describe how those variables are related but, in addition, any such tradeoff must be known and stable over time. Second, the unobserved natural rate of unemployment must be estimated with sufficient accuracy that any gap between it and the actual rate of unemployment will give a reliable indication of whether the stance of monetary policy should be changed.
The behavior of unemployment and inflation in the not-too-distant past might provide some perspective on whether these conditions are likely to hold today. Specifically, the first two figures below show that, for a four-year period between May 1997 and May 2001, while the unemployment rate was at or below 4.9 percent, the inflation rate as measured by the year-over-year percentage change in the price index for personal consumption expenditures, excluding food and energy, never exceeded two percent and often ran below 1.5 percent. In fact, inflation and unemployment fell in tandem throughout most of the 1990s. To be fair, inflation did accelerate as unemployment declined during the recovery from the 2001 recession. But, overall, the behavior of the two variables begs the question of whether any association between them is a coincidence or reflective of a reliable tradeoff that the Fed can exploit in pursuing its objectives.
If questions persist about the reliability of signals derived from a Phillips curve, other data may provide a useful cross check. The quantity theory of money, attributing movements in inflation to changes in the money stock instead of unemployment, provides an alternative view. Thus, our third graph plots the cyclical component of a broad monetary aggregate, Divisia MZM, constructed using the one-sided version of the Hodrick-Prescott filter described by James Stock and Mark Watson in their 1999 paper on inflation forecasting.
This chart shows that, from a quantity-theoretic perspective, three major episodes of monetary tightening have occurred since 1990: the first in the mid-1990s, when inflation was falling, the second in the years leading up to the financial crisis and “Great Recession” of 2007-2008, and the third running from late 2009 through the middle of 2011. This last observation, in particular, suggests that the FOMC’s multiple rounds of “quantitative easing” did not consistently generate the broader money growth that would have been needed to prevent inflation from falling well below target in recent years. Moreover, it reveals that declining interest rates may better reflect weak economic activity than an accommodative stance of monetary policy.
Since 2012, Divisia MZM has moved back above trend, indicative of renewed monetary stimulus that should allow inflation to return to two percent. Nevertheless, these data bear watching, as the FOMC debates how quickly to continue along the path towards tighter policy. Indeed, to avoid prolonging the current period of below-target inflation, slower money growth would serve clear warning that the Fed needs to pause before raising interest rates any further.