Friday, January 14, 2011

Thoughts on the Phillips Curve

The Phillips Curve theory of inflation says that inflation is a by-product of strong growth. When an economy "overheats" and things are humming along at or close to "capacity," then supply can't keep up with additional demand and producers start raising their prices. Conversely, when the economy goes into a slump and a lot of economic "slack" develops, then everyone has spare capacity, there's lots of price competition, supply exceeds demand, and prices tend to fall. It's all very intuitive, but from a monetarist's perspective, its dead wrong.

It's true that if the supply of apples exceeds the demand for apples, then the price of apples is very likely to fall. But that's a statement about the relationship between the supply of and the demand for apples; it doesn't say anything about the relationship between the market for apples and the amount of money in the economy. Inflation is a condition wherein the supply of money exceeds the market's demand for money, so an excess of money tends to drive all prices higher. Imagine if the amount of dollars in circulation increased by 100% overnight: the price of just about everything in the economy would quickly start rising, and in the end, the price level would end up rising by 100% or so. Even if there were more apples on the market than people wanted, the price of apples would rise if the money supply doubled. I've lived in hyperinflationary times (the late 1970s in Argentina), and I know that prices can rise even if the economy is in a deep recession.

The Phillips Curve theory got a big boost in the 1970s, because the relationship between inflation and capacity utilization (see the chart above) was very tight. There was a reliable, 17-month lag between changes in capacity utilization and the inflation rate. That lag reflected the fact that it takes time for the economy to adjust to changes in underlying monetary conditions.

But then the relationship stopped working, starting in 1982. Capacity utilization rose through 2000, but inflation fell. Since then there has been a modest correlation between the two, but nothing like what we saw in the 1970s. My explanation for why the Phillips Curve worked in the 1970s is that the Fed was following a very reactive strategy: tightening after inflation rose, then easing after inflation fell. They were always adjusting to the realities of the economy after the fact; easing for too long, and then abruptly tightening after inflation was rising and entrenched.

But in the 1980s the Fed started pursuing a very tough line against inflation, proactively tightening even before inflation rose (e.g., the late 1990s). In 1998 and 1999 I started worrying that they had tightened way too much, and that deflation was a serious risk. By 2002 deflation was indeed a major concern for the Fed, and so from about 2003 on, the Fed became reactive again, easing in response to the fear of deflation, even as there were many signs that policy was too easy (e.g., rising commodity, gold, and housing prices), and so the correlation between capacity utilization and inflation has increased somewhat.

Still, the huge swings in capacity utilization and inflation in recent years has been nothing compared to the 1970s. But it remains the case that the Fed is once again behaving in a reactive, rather than proactive manner. The FOMC assigns much more importance to the relatively low rate of capacity utilization and the amount of economic "slack" there appears to be today, than to the impressive and ongoing rally in commodity prices and gold prices, or to the historically weak level of the dollar. (And recall that it was the collapse of the dollar in the 1970s that really got inflation going.) So it's reasonable to think that the recent surge in capacity utilization ought to be followed by at least a mild uptick in inflation.

Given the 17-month lag between capacity and inflation that played out so well in the 1970s, we may well have seen the low in the CPI for the next several years. And that is exactly what the Fed wants to see—higher inflation. Never doubt the Fed's ability to get what it wants.


septizoniom said...

the fed doesn't understand that it's monetary area is china, japan and germany. aggregated, esp with china, we are at capacity.

Anonymous said...

Hola Scott, just a question.

I like your analisys about reactive/proactive FED policy.

I´m a student of the markets and I would like to deepen in central banking policy, their way of thinking and in general anything related to central banking.

Can you recommend me one or two good books about the topic?

thank u

Benjamin Cole said...

I notice that when demand and production expand, you actually get a counter-inflationary push for a while, as more units get spread across the same amount of overhead and fixed costs.

Right now, unit labor costs are falling, and property rents of all kinds are softer than brown bananas. I just don't see how that sets up for inflation. you have 70 percent of business costs going down or sideways.

A few years to five percent inflation. to deleverage, would hardly be the end of the world, and would bring properties above water, giving banks and property owners a lot more breathing room.

Japan tried to go the other direction--stable prices, declining asset values, and the result has been a tragedy for the island nation.

Bond traders expect Japan to be sick for another decade. Boy, Japanitis is the most dangerous disease I can imagine.

Think about 30 years of deflation, and all your investments becoming worth less every year. You have Japan in mind.

Benjamin Cole said...

BTW, take a look at that trend line on core CPI for the last 20 years--you can't really be scared of inflation now, can you?

Scott Grannis said...

Contrarian: for a different look at the issue of central banking, try this:

"Monetary Policy, A Market Price Approach", by Manuel H. Johnson and Robert E. Keleher

Anonymous said...

Thank You very much Scott. I will enjoy your recomendation!