Some coaches are throwing out their playbook.
I’m not talking football. Members of the Federal Open Market Committee (FOMC) of the US Federal Reserve are charged with the duty of “coaching” the economy, but are divided over what game strategies they should use.
The old economic playbook is known as the Phillips curve. In 1958, economist A. W. Phillips published a report detailing the negative correlation between inflation rates and unemployment in Britain. This empirical relationship was soon confirmed by other economists using US data.
According to the theory behind Phillips’ work, policymakers have a clear choice: how much inflation are they willing to tolerate in order to get people back to work? If the Fed expands the money supply with low interest rates, as it has been doing now for nine years, it moves the economy along the Phillips curve to a point of lower unemployment, but at the cost of higher inflation.
The US national unemployment rate is now 4.9 percent, what economists generally consider normal. A “normal” rate of unemployment is not an exact number but refers to the amount of unemployment the economy experiences when everyone is producing goods and services at their full potential.
But as our economy moved to this normal unemployment, inflation has remained low in contrast to the Phillips curve model. Through July, the US Consumer Price Index (CPI) is rising at an annual rate of only 2.1 percent, very close to the historical average and the FOMC’s “inflation objective” of 2 percent annually. The economy is simply not producing the expected high inflation.
So maybe the game has changed. Minutes from the most recent FOMC meeting indicate that policymakers are divided on this question.
At their July meeting some FOMC members expressed the view that “labor market conditions were at or close to those consistent with maximum employment and expected that the recent progress in reaching the Committee’s inflation objective would continue.” This group then “judged that another increase in [interest rates] was or would soon be warranted, with a couple of them advocating an increase at this meeting.”
At the same meeting other FOMC members “concluded that the Committee should wait to take another step in [raising interest rates] until the data on economic activity provided a greater level of confidence that economic growth was strong enough to withstand a possible downward shock to demand.” These policymakers apparently think the game has changed.
Perhaps it’s the case that the old playbook never worked at all.
A decade after Phillips’ finding of a tradeoff between inflation and unemployment, economists Milton Friedman and Edmund Phelps showed that such policy tradeoffs were only good for a short period of time, if at all. These economists found that when the Fed lowered interest rates by increasing the rate of growth in the money supply there was no real effect on the economy. The Fed can’t do anything for the economy’s long-run unemployment rate.
Today, the economy is simply too weak for interest rates to change the incentives consumers have to buy goods and services, thus raising prices. The strong force holding back growth has not changed – business conditions are uncertain.
The willingness of companies to invest and grow is being influenced by uncertainty at home and abroad. Fiscal challenges at both the federal and state level present an unclear picture for business investment, and weak economic activity around the globe suggests fewer opportunities for business expansion.
With the upcoming election in November the domestic concerns are unlikely to be resolved until sometime in 2017. This uncertainty clearly holds back many firms from investing in new products or new markets, which would expand output and economic growth.
There is also considerable economic uncertainty outside the US and more evidence that monetary policy is ineffective. The central banks of both Europe and Japan have lowered interest rates to below zero with little economic growth to show for it.
With a weak economy and uncertain outlook investors face limited choices. Prices for financial assets reflect the fact that the headwinds facing businesses have not improved.
Investors continue to seek the safety of US government debt. In the last twelve months the yield on the 10-year Treasury note has fallen from around 2.1 percent to just over 1.5 percent. The yield spread, or difference between the 2 and 10-year notes, is only 0.8 percent, indicating the market expects very low inflation and economic growth ahead.
The bleak economic outlook outlined here may change next year if the outcome of the U.S. presidential and congressional elections brings more clarity for business owners. Business conditions need to improve, with more certainty over tax and regulatory policy.
To see real economic growth we need to throw out the monetary policy playbook altogether.
Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.
The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.