Applying Phillips Curve to Fed’s inflation-unemployment equation

The growth-inflation dynamics as a guide to policymaking is undergoing changes in the context of the peculiar financial and economic conditions, which economies, and more particularly central banks, are facing currently.

The Phillips Curve is probably becoming more relevant here. Developed by AW Phillips, the thesis is that inflation and unemployment are inversely related. With economic growth, some amount of inflation too emerges, and this results in more production and employment. Therefore, inflation and unemployment have an inverse relationship.

In the 1970s, many economies witnessed low rates of economic growth and low levels of employment with inflation. There were also instances of high inflation and low growth. This led to the question of the credibility of this basic relationship. But there is a return to understanding this interesting trade-off more seriously.

The US Fed is faced with high unemployment and low growth, and they feel pushing up the price levels could be an ideal thing to bring growth back to the economy. The Fed has been targeting 2 per cent inflation and the price level has never been there. So, inflation is falling short of the target. The US central bank has brought about a drastic change in its approach and said it needs inflation to be higher and the target would be an average inflation of 2%, which signals a period of higher inflation above 2%. The Fed obviously feels higher inflation will help promote production and growth, and thereby, higher employment.

From the Fed Chairman’s Press Conference:
“The pandemic has also left a significant imprint on inflation. For some goods, including food, supply constraints have led to notably higher prices, adding to burden on those struggling with lost income. More broadly, however, weaker demand — especially in sectors such as travel and hospitality that have been most affected by the pandemic — has held down consumer prices, and overall inflation is running well below our symmetric 2 per cent objective.

“In earlier decades, when the Phillips Curve was steeper, inflation tended to rise noticeably in response to a strengthening labour market… We have also made important changes with regard to the price-stability side of our mandate. Our longer-run goal continues to be an inflation rate of 2 per cent. Our statement emphasizes that our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well-anchored at 2 per cent.

“However, if inflation runs below 2 per cent following economic downturns, but never moves above 2 per cent even when the economy is strong, then, over time, inflation will average less than 2 per cent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull the realised inflation down. To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 per cent over time.

“Therefore, following periods when inflation has been running below 2 per cent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time…In seeking to achieve inflation that averages 2 per cent over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting…The revisions to our statement add up to a robust updating of our monetary policy framework.”

This is a natural extension of a policy of liquidity expansion, and the Fed policy may likely continue to be accommodative and soft for a longer time than expected. Fiscal and monetary stimulus leads to an increase in aggregate demand, higher incomes and employment. Unemployment gradually comes down. The cheaper US dollar liquidity may trigger a weaker US currency, but that would ultimately pave the way for the restoration of growth and trade competitiveness.

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