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The Fed's Trade-Off between Inflation and Jobs Is a Myth

August 13, 2015 in Economics

By James A. Dorn

James A. Dorn

The idea that there’s a trade-off between inflation and unemployment seems embedded in the Federal Reserve’s psyche.

The Fed has not increased its benchmark federal funds target rate since 2006. It’s waiting to see if a tighter labor market will push up wages and prices, so the Fed can achieve both full employment and its inflation target of 2%.

The Fed’s adherence to a negatively sloped Phillips curve — predicting lower unemployment obtained by higher inflation — is a flawed model for monetary policy.

Indeed, money doesn’t even enter the analysis, because the implicit assumption is that inflation is caused not by too much money chasing too few goods but by higher wages (caused by a tight labor market) pushing up costs and prices.

It is time to rethink monetary policy and to banish the Phillips curve to the dustbin of history.”

The Phillips curve mentality is evident in the following statement by Atlanta Federal Reserve President Dennis Lockhart:

“I think a policymaker has to act on the view that the basic (negative) relationship in the Phillips curve … will assert itself in a reasonable period of time as the economy tightens up.” He finds the logic of the Phillips curve “compelling.”

Most economists would agree that even if unanticipated inflation could reduce unemployment in the short run, any trade-off is tenuous and probably will last no more than a year.

In the longer run, once expectations adjust to reality, the unemployment rate will move toward its natural rate, consistent with market forces — and there will be no permanent trade-off between inflation and unemployment.

Hayek And Friedman Saw It

More important, the stagflation of the 1970s gave credence to the idea that the Phillips curve could be positively sloped with inflation and unemployment moving in the same direction. The positively sloped Phillips curve was foreseen by Nobel laureate economist Friedrich Hayek and anticipated by Milton Friedman in his 1976 Nobel lecture.

In 2002, William Niskanen, a former member of President Reagan’s Council of Economic Advisors, constructed a model to test the Phillips curve’s trade-off hypothesis. He found “no trade-off of unemployment and inflation except in the same year” and “in the long term, the unemployment rate is a positive function of the inflation rate.”

His policy recommendation was that “a monetary policy targeted to achieve a steady growth of aggregate demand at a zero inflation rate is also consistent with the lowest possible sustainable unemployment rate.”

If …read more

Source: OP-EDS

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