Markets once again are waiting breathlessly for a decision on short-term interest rates by the FOMC, the Federal Reserve’s monetary policy making arm. All signs point to no change in interest rates. More interesting is a possible change in how members of the FOMC are thinking about the economy.
For years, most members of the FOMC have used the Phillips Curve framework in setting monetary policy. This is done against the backdrop of the Fed’s so-called dual mandate to promote maximum employment and low inflation. The Phillips Curve postulates a negative relationship between unemployment and inflation. Thus, a falling unemployment rate foretells higher inflation in the future.
Now two Fed Governors (members of the FOMC) have questioned the relevance of the Phillips Curve in separate speeches recently. The one-two punch was delivered by Lael Brainard and Daniel Tarullo. In Brainard’s words, “I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation.”
At the Kansas City Fed’s annual Jackson Hole conference last August, two former Fed economists questioned the Phillips Curve. They argued the relationship between inflation and unemployment has never been tight.
The Fed Chair, Janet Yellen, who has been largely absent from public view, remains wedded to the Phillips Curve. It is unusual for two Governors to so publicly deviate not only from the Chair’s policy guidance but also from the policymaking framework. Is Janet Yellen losing control of the FOMC?
In reality, labor markets are not so tight and there is just no sign of higher inflation in the near-term. I made those points in an August 24th op-ed in the Wall Street Journal.
Adding to the dilemma facing the FOMC is that markets are signaling that short-term interest rates should be lower not higher. New issues of short-term Treasury bills have been issued with a zero interest rate (though the most recent auction produced mildly positive interest rates). In secondary markets, bills have traded at mildly negative interest rates. Moreover, short-term interest rates are negative in around 20 countries mostly in the European Union (HT: Walker Todd).
In sum, we have a Fed divided and markets signaling a move down not up in interest rates. That makes for enhanced uncertainty in financial markets.