The Phillips Curve, an economic model developed by A. W. Phillips purports that inflation and unemployment have a stable and inverse relationship.
This has been a fundamental guiding economic theory used by the Fed for decades to set interest rates.
A new Fed Study shows the Phillips Curve Doesn’t Work.
A fundamental relationship of mainstream economic theory at the heart of the Federal Reserve’s strategy for setting interest rates has been a poor guide for policy makers for at least three decades, according to a study by the Philadelphia Fed’s top-ranking economist.
The paper, co-authored by Philadelphia Fed Director of Research Michael Dotsey, shows that forecasting models based on the so-called Phillips curve, which asserts a link between unemployment and inflation, don’t actually help predict inflation.
“Our results indicate that monetary policymakers should at best be very cautious in their reliance on the Phillips curve when gauging inflationary pressures,” Dotsey and Philadelphia Fed economists Shigeru Fujita and Tom Stark wrote.
Their study is timely. Fed officials have been surprised by a deceleration in U.S. inflation over the past several months despite a continued decline in unemployment, the opposite of what the Phillips curve relationship would predict.
The Philadelphia Fed economists found that rising unemployment was sometimes able to help predict lower inflation, but falling unemployment didn’t help predict higher inflation. They noted that was particularly the case during the 1970s and early 1980s when the Fed responded to runaway inflation by raising rates so high that the U.S. economy fell into recession.
“Our evidence may indicate that using the Phillips curve may add value to the monetary policy process during downturns, but the evidence is far from conclusive,” they wrote. “We find no evidence for relying on the Phillips curve during normal times, such as those currently facing the U.S. economy.”
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