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Janet-Yellen Copyright Mark Wilson, Getty Images

Is The Phillips Curve Broken?

Informa’s Chief Macro Economist David Ader on how the traditional metrics guiding Federal Reserve decisions may no longer be useful.

It wasn’t exactly a slow news week, but still The New York Times had the temerity to take away space from any number of its Harvey Weinstein updates to tell us, way back on page four of the business section, “Fed Still Puzzled by Inflation, but Rate Increase Is on Track.”  This has been the story for a year at least and the question of why inflation is low continues to give way to the Fed’s confidence in its models that say it will eventually rise. I get they want to hike; I guess everyone does. Why they want to hike is another story though centered essentially on the Phillips Curve, which is rather a faulty, but persistent, argument.

Which is why it’s an honest Financial Times that offers a big story, “Central bankers face a crisis of confidence as models fail,” and summarizes it with, “In short, the new masters of the universe might not understand what makes a modern economy tick and their well-intentioned actions could prove harmful.”  I can’t add too much more to that.  The article talks a good deal about the Phillips Curve and how many central bankers are questioning their own fundamental approach to see if, in Yellen’s words, “our framework for understanding inflation dynamics could be misspecified.”

I’ve written this before and will write it again: The Fed’s dual mandates of employment and inflation have the added element—say a soft third mandate—of financial stability. Several on the Federal Open Market Committee have been voicing concerns over various risk asset markets heating up, in large part a function of low interest rates and the liquidity-providing quantitative easing purchases, so with the Phillips Curve in one hand and record stock markets in the other, Yellen can’t quite wave a red flag—she’s but a two-handed economist. Not only does “persistently easy monetary policy” raise the risk of an overheated economy, it “might also eventually lead to increased leverage and other developments, with adverse implications for financial stability,” she said in a speech.

One of the bright spots this week was the appearance of Hoisington’s Q3 Review and Outlook. They are sticking to their bullish guns, which makes me a bit unsteady with my own, current, rather more bearish view (though seeing pullbacks as buying opportunity). They again school me on the relevance of slow money growth and weak velocity towards a slow economy and resulting constructive view on rates.

To wit, with the Fed in the process of reducing its balance sheet, according to Van Hoisington and Lacy Hunt, the M2 growth rate will decrease, which they see down 4.2 percent by the end of the year from 7 percent last year, and falling 2.8 percent in the first nine months of 2018, stating balance sheet reduction won’t be sustained next year. Citing the Fisher equation for nominal GDP (M2*velocity = GDP), the results could be economically onerous to say the least. Velocity is at a historic low of 1.43.  So, the issue for GDP is low velocity and slow money growth.

David Ader is Chief Macro Strategist for Informa Financial Intelligence.

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