The Fed, the Phillips Curve, and Inflation

February 2, 2015

The Fed, the Phillips Curve, and Inflation Photo

Last week, the Federal Reserve (Fed) gave us our first glimpse at its thinking since the beginning of the year. The Fed kept its pledge that it could be patient in raising interest rates and stated that the economy and employment continue to improve. The Fed further stated that it expects inflation to decline in the near term but increase toward 2.0% over the medium term as the labor market improves.

Over the past year we have seen unemployment fall, but we have not seen a significant improvement in wage growth. Wage growth is an important factor in the level of inflation. The Fed seems to be relying on the theory of the Phillips curve in anticipating future inflation. In economics, the Phillips curve expresses the historically inverse relationship between rates of unemployment and the corresponding rates of inflation that result in an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of inflation.

But does the Phillips curve work? And what is the natural rate of employment in the U.S. economy? We believe that the type of jobs created -- combined with a corresponding shortage of candidates to fill those jobs -- is what drives wage growth. The current U.S. economy is very uneven in this regard. Some skills are in high demand and have tight labor markets, while at the same time many of the jobs created post-2008 have been at lower wages than pre-crisis. As a result, the unemployment rate probably needs to fall even further in order for us to see wage gains.

Before the fall in oil prices, U.S. consumer prices sat below the Fed's target of 2.0% for 31 straight months. Given the Fed's dual mandate of employment and inflation, the Fed may decide that it doesn't need to raise rates as soon. The uptick in volatility in the equity market and the rapidly strengthening dollar are other factors that could influence the Fed's decision. We believe that unless the economy exhibits growth greater than 3.0%, along with increased wage inflation in the first half of the year, the Fed can hold off on raising rates until there are signs of rising inflation. The risk to the U.S. economy is still to the downside, and, because of low inflation, the Fed has the luxury to wait.

For this week, we expect to see a favorable unemployment number on Friday, but look for the average hourly earnings number to be closely scrutinized after last month's decline of -0.2%. Choppiness in the markets has become the norm for now, with earnings and geopolitical events adding to volatility.

Tags: Monday Morning O'Malley | U.S. economy | Inflation | Federal Reserve | Interest Rate | Volatility | Unemployment report | Wages

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