Quick Thoughts On The Failure Of Fed-Engineered Unemployment

I am a skeptic of thinking about low unemployment as a bad thing – which is what people who think about policy in terms of the Phillips curve do. Now a study by the Philly Fed is saying that the Phillips Curve is a poor forecasting tool. Will this have any meaningful impact on policy?

Some thoughts below:

Here’s the deal: a lot of people at the Fed think of low employment as something that stokes inflation and makes the Fed’s job harder. On the one hand, the Fed wants some inflation. Hence the meme on Amazon’s lowering prices at Whole Foods making the Fed’s job harder. But on the other hand, the Fed only wants moderate inflation – optimally 2%. That’s its target.

But a “very, very low unemployment rate” makes that target harder to achieve. At least that’s what NY Fed President Bill Dudley has said. And what he basically means is that the Fed wants to engineer the economy so that enough people remain unemployed to keep inflation from taking off and becoming entrenched. Let’s call this Fed-engineered unemployment or FEU (pronounced like the word FEW).

But what if the benefits of FEU were just a myth? For example, the Philly Fed paper says “forecasts from our Phillips curve models tend to be unconditionally inferior to those from our univariate forecasting models.” That’s Fedspeak for “if you want to forecast inflation accurately, don’t track two things as a trade-off to one another.”

Interestingly, the Philly Fed paper found that any trade-off that could actually be forecasted only happened when the economy was weak – meaning when the Fed would be cutting rates or holding steady. So the Fed’s own research now suggests that raising rates solely because unemployment was ‘too low’ makes absolutely no sense.

We can hypothesize why the Phillips Curve doesn’t add value in making policy. For example, some people point to technological change, globalization, and the waning clout of unions as factors. Irrespective, it is undeniably true that this Phillips Curve framework doesn’t help and that it helps least when the economy is firing on all cylinders.