Wednesday, February 28, 2007

News? Not really.

Let's take a break from talking about the rout for a moment.

A couple days ago, Greg Ip (often called a Fed mouthpiece), wrote a piece on a new inflation model the Fed is using. This one downplays Phillips Curve effects and focuses more on inflation expectations.

I don't really think this is news. The Phillips Curve fell out of favor both at the Fed and in academia a long time ago. Going all the way back to the Volcker Fed, the idea that unemployment could be targeted was all but dead. Hell, Edmund Phelps won a Nobel Prize for work that helped debunk the Phillips Curve. I think once you actually win the Nobel, your ideas are mainstream.

So if the Phillips Curve is all but dead, why is Greg Ip talking like the Fed is still using it in setting policy? I think you need to read between the lines here, as well as bring your own background into the discussion. Inflation expectations have been a very common theme in Fed papers and speeches from the last few years. Labor market tightness (or slack) comes up from time to time, but often in conjunction with productivity. Plus to ignore the labor market would be silly. In order to have consumer inflation, consumers must spend more. In order for them to spend more, they must have more income. In a world where the effective money supply is hard to measure, income paid to consumers is one way to see whether the money supply is increasing or decreasing. By this view, labor market tightness is not causing inflation, but is an indicator of incipient inflation problems.

So if you read between the lines on Ip's article, it might be that the Fed's official inflation models have had less and less influence on actual policy for some time. Maybe internal politics or other goals prevented a full revision of the model for some reason.

So I say Ip's article doesn't suggest anything of substance is changing here. Probably only something of appearance.


Anonymous said...

I think that the Fed uses "expectations" as a tool for their bully pulpit to keep the vigilantes in check and the disinflation crew at bay ... that way they can keep their policy unchanged for longer than normal as they pursue it until it seems to work

then , they can declare victory

Vivek said...

Although the original Phillip's curve has been debunked, if inflation does go above expected inflation, producers temporarily think demand is increasing at a given price and so increase employment.

To the extent to which this is true, I believe the paper was saying the relation has declined.

Vivek said...

Forget it. I think you're right. There's not much new here, but I think it was trying to explain empirically why the relation doesn't hold. I don't know if that's been done before, if only because it requires a lot of time series data (i.e. waiting).

Tom G. said...


If we go all conspiracy theory on this, and assume Ip is saying what the Fed wants him to say, then I'd say the Fed wants people to pay less attention to jobs numbers.

Could be that the Fed thinks job growth will slow but they still want to keep rates where they are?