In the 2017 Strategic Investment Conference interview with Lacy Hunt entitled The Fed’s Monetary Policy is Destabilizing, the failure of existing monetary policy is simplified to its core. The topic has been previously addressed in several articles under the Economic Environment tab, including The Questionable State — and Abusive Use — of Economics, however this time the comments regarding Federal Reserve policy come from one of the world’s most brilliant and forward-thinking economists.
“They’re focused on something called the Phillips Curve — that there’s an inverse relationship between the unemployment rate and the inflation rate — and in my view that’s very flawed.”
“The inflation rate is a lagging economic indicator; it typically does not decline until economic activity is already softening. And the unemployment rate typically does not rise until conditions are deteriorating.”
“When the Fed responds to a non-fundamental increase in the inflation rate, what they do is they increase the financial instability — they increase the risk of recession, they increase the risk of too much inflation down the road, and so the mandate of the Federal Reserve inherently leads to a destabilizing monetary policy.”
– Lacy Hunt, The Feds Monetary Policy is Destabilizing
Monetary policy continues to fail society because of the policy errors that result due to the misplaced belief that the Federal Reserve’s fundamental model allows for proactive policy; yet, at its best the fundamental model is reactive, and at its worst it’s misleading.
The Federal Reserve is tasked with a “dual-mandate” — (1) target low & stable inflation, and (2) target high employment — and the Phillips Curve model is used to try to accomplish those tasks. Yet the reason this is nearly impossible to accomplish is that the inflation and unemployment rates both react to economic conditions, they don’t predict — they show an image of previous economic events, those already “in the rear view mirror”, yet the view and conditions behind the “car” are not always the same as those in front of the “car”. By the time the Federal Reserve begins to react, the economic events that caused the shift in inflation or unemployment may already be moving in the opposite direction; however, their model has not yet alerted them to the new change and their actions have the potential to push the economy off course in that new direction. If you’re driving along a potholed street using the rear view mirror as your only guidance, when you finally hit a pothole and see it in the rear-view mirror do you turn away from it in an attempt to avoid the next one? — you may get lucky, but you may also be turning directly into an even bigger hole.
Worse yet, the Phillips Curve was developed as a guide-map to this potholed road, a plan on how to react after the time-for-reaction has passed. Imagine in this rear-view-mirror/pothole experiment that you’re going to design a roadmap to avoid potholes. You’re driving along using your rear view mirror as guidance and you hit a pothole, you decide to turn to the left a bit to “avoid the next one”; since you don’t hit another pothole for a little while you decide to note “left” as the first instruction for the map. When you eventually hit another pothole you again decide to turn to the left a bit; you don’t hit another pothole for a little while and note “left” for the second instruction. If this process continues for a while you may actually begin to believe that turning left helps avoid potholes, even if the road up in front of the car now has more potholes on the left than it did before.
The Federal Reserve’s rear-view-mirror roadmap, “the Phillips Curve”, is based on the expectation that the unemployment rate and the inflation rate are inversely related (i.e. if unemployment is high, inflation is low; if unemployment is low, inflation is high).
Yet the actual relationship between the inflation rate and the unemployment rate can be seen here:
Chart Source: John Hussman’s weekly market comment entitled, Will the Real Phillips Curve Please Stand Up?. Data since 1947.
Since there is not a cluster of dots forming a downward sloping curve, there is not a strong relationship between the unemployment rate and the inflation rate.
“Much of the intellectual basis for the Federal Reserve’s dual mandate — ‘to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates’ — is based on the belief in what economists call the Phillips Curve. The Phillips curve, named after economist A.W. Phillips, is widely understood as a ‘tradeoff’ between inflation and unemployment. The idea is so engrained in the minds of economists and financial analysts that it is taken as obvious, incontrovertible fact. High unemployment, the argument goes, is associated with low inflation risk, and in that environment, policy makers can safely pursue measures targeted at increasing employment, without undesirable consequences for inflation.”
– John Hussman, Will the Real Phillips Curve Please Stand Up?
And unfortunately, the monetary-policy oversight referenced in the last line is the reason for much of the economic imbalance, stagnant growth, wealth disparity, asset bubble complications, and social unrest occurring in the 21st century — when a small economic fire emerges, the Federal Reserve often tries to douse the fire; their “suppressant” is a bottle, labeled water by the Phillips Curve, containing enough kerosene to convert the fire to a blaze.
“An enormous amount of human misery could be avoided if central bank authorities . . . abandoned their endless bubble-blowing exercises in the hope of exploiting some tradeoff between unemployment and general price inflation that simply does not exist. Pursuing general price inflation does not somehow ‘buy’ more jobs. It also does not raise real wages. It lowers them.”
After viewing even a sample of the seemingly endless Federal Reserve missteps one would think that the roadmap would be questioned more than it has been and that the policy projections and forecasts would diminish; unfortunately, these are our modern day shamans, portents, and “magic-men” — divinations promulgated from a Nostradamus of economics.
We’re at “Full Employment” and Why No One Cares
When taking a bit more than a cursory view of the unemployment rate, one may begin to wonder why such a weak statistic is so often referenced, why it influences monetary policy decision-making, or even why it’s used at all when referencing the employment situation.
The U.S. unemployment rate recently reached the Federal Reserve’s level indicating “full employment” — a nice daydream statistic to focus on . . . the Federal Reserve can congratulate themselves on their accomplishment, and the “good” employment situation can be broadcasted for political purposes persuading the economically uneducated that broad steps forward are being made in this continued economic recovery.
But what good is an employment statistic if the quality of employment is not considered? Monetary policy continues to persist with the delusion that jobs are “empty holes” & that people are “pegs” to fill those holes. By using the unemployment rate to judge the full employment condition of the economy, one overlooks a whole range of very important issues regarding quality of work, including among others:
- under-employment situations (individuals unable to maximize their skills, working irregularly or part time)
- labor force participation that has fallen due to individuals dropping out of the labor force (those that would like to work but have simply given up due to an inability to find work), and
- share of Gross Domestic Income[GDI] (the percent of an economy’s total income actually received by employees).
Because of the oversights of the unemployment rate statistic, the employment-to-population ratio is often used by those interested in a deeper analysis of the employment environment.
One can see that almost 10 years after the financial crisis the employment condition is still far below previous highs. However, the employment-to-population ratio shows a slightly lopsided view of the employment situation: during the 1950s, ’60s, and ’70s, one-income households were more prevalent; there were less working-age people in the workforce because they didn’t need to be working — the share of GDI was higher then.
And as share of GDI fell, more workers were drawn into the workforce to maintain previous household income levels; the shift from one-income households to two-income households eased the pressure created by a falling share of GDI.
One can see the relationship between the employment-to-population ratio and share of GDI with a regression analysis.
Many thanks to @archibald_rust for this regression analysis.
However, a threshold was eventually reached where additional labor could not be pulled into the workforce to compensate for the fall in share of GDI, resulting in the outliers seen since the 2000s.
Weighting the employment-to-population ratio by share of GDI begins to clarify more recent workforce issues; more specifically, that although the unemployment rate is paraded as a sign of “full employment” the workforce couldn’t care less — the availability/quality of work still hasn’t recovered, and their share in the economy’s income has been falling for years.