The Crux of the Fed’s Dilemma

With inflation slipping further below 2 percent, and Greece, Puerto Rico and China firmly on investors’ watch lists, here’s why it appears the Fed will still raise rates this year

The US Federal Reserve (Fed) is tasked with the dual mandate of promoting maximum employment and stable prices. Under normal circumstances it achieves this by adjusting policy interest rates to steer the economy to an appropriate level of activity. Too low a level would yield unemployment, too high a level, inflation. The Fed’s ability to perform this delicate balancing act depends crucially on a two-part transmission mechanism, specifically a link between interest rates and economic activity and one between activity and inflation.

Economists have generally accepted that both exist. And there seems little doubt that high interest rates reduce activity by raising the cost of big-ticket consumer items such as cars and capital items such as residential housing, industrial plants and durable equipment. But the link from activity to inflation has changed over the last 20 years, and might even have disappeared altogether, undermining the Fed’s inflation target.
The Fed has indicated it needs to be reasonably confident it can get inflation back up to 2.0 percent before it will move ahead with ending its zero-bound interest rate policy. However, with the transmission seemingly broken, the Fed can keep revving the employment engine and it may hardly get inflation to budge.

The Phillips Curve through Time
The link between activity and inflation is described by the Phillips Curve (Figure 1). This traces out a relationship between the level of unemployment (on the x-axis) and wage inflation (on the y-axis). The curve was discovered by a New Zealand economist, William Phillips, in 1958. But it reached its heyday 10 years later when Milton Friedman augmented it with an inflation expectations component that subsequently allowed him to explain the phenomenon of stagflation — a period of simultaneously high unemployment and inflation — which gripped the US economy during the 1970s.

The existence of a Phillips Curve was also at the heart of former Fed Chairman Paul Volcker’s battle to rid the economy of inflation in the 1980s (Figure 2). The Fed raised the federal funds rate to unprecedented levels early in the decade, causing the unemployment rate to rise to 9.7 percent in 1982 and wage inflation to fall from 8.6 percent in 1981 to just 2.2 percent by 1986. But while subsequent (and sizable) moves in the unemployment rate have caused inverse moves in wage inflation they have been relatively muted. Indeed, wage inflation hovered between 2.1 and 4.0 percent between 1986 and 2011, and only slipped slightly (and briefly) below that level in the aftermath of the global financial crisis despite the unemployment rate hitting 9.6 percent. In simple terms, the Phillips curve has become flatter.

Of course, the Fed is not interested in wage inflation per se, but rather in price inflation in general, focusing in the short term on Core Personal Consumer Expenditure (“Core-PCE”) inflation, which aims to glean as true a picture as possible by excluding the effects of food and energy swings. Still, the experience of Core-PCE inflation over the past three decades is similar to that of wages (Figure 3). Core-PCE decelerated sharply to 3.2 percent in 1987. Then after accelerating briefly in 1988, it began a decade-long decline to just 1.2 percent in 1998, and has hovered between 1.2 and 2.2 percent since, seemingly immune to even outsized moves in the unemployment rate.
The implication is that businesses have lost pricing power, so even if wage costs increase because of labor market conditions employers are unable to pass them along to their customers, but must rather absorb them as lower profit margins.

At least in the manufacturing sector, there is an intuitive explanation for why this has happened — Globalization. Even if the US labor market becomes extremely tight there is a limit to how high workers can bid wages, because if wage costs rise too high jobs can simply be shipped overseas. Similarly, if businesses are obliged to make some concessions on compensation to retain labor, they are limited in what they can pass through to customers because, again, of direct competition from abroad.

It is perhaps more difficult to understand why the Phillips Curve has also flattened in the service sector, but not if you think about just how pervasive globalization has become in today’s economy. More and more service-sector companies are becoming exposed to competition from abroad. The communications revolution allows computer programs to be developed anywhere, MRIs to be analyzed anywhere, and a whole variety of business processes to be performed anywhere.
Moreover, the off-shoring of manufacturing jobs naturally creates an additional supply of workers for service-sector jobs.
And that exerts downward pressure on wages in the sector, particularly towards the lower end of the spectrum.

It is no wonder then that wage inflation barely breached 4.0 percent and Core-PCE inflation barely, and only briefly, 2.0 percent even when the unemployment rate fell below 4.0 percent in 2000.

There is also some support for these hypotheses in the academic literature. Peach et al (2013)1 find that core inflation in the goods sector has become less related to domestic labor market slack and more related to import prices. Ebenstein et al (2015)² report wage declines for US workers most exposed to globalization, and also for those who relocate to the service sector. And Seydl and Spittler (2015)³ show that post-1994 (the introduction of NAFTA) the Phillips Curve flattened in both the goods-producing and service sectors.

When the Curve Goes Flat
The foregoing analysis poses an intriguing question: Why does the Fed need to begin tightening if unemployment is still above its full-employment equilibrium and inflation is essentially drifting sideways about 0.6–0.8 percentage points below its target? Indeed, these factors have already contributed to a revision of market expectations of the timing of Fed liftoff.
Earlier this year, most analysts predicted a June start to Fed tightening. The futures market is now pricing in about a 50/50 chance of a first rate hike in September. But why hike this year at all?

After all, if the Phillips curve has flattened, wage inflation will remain largely unchanged even if the unemployment rate falls below the level normally associated with full employment.
And the effect on price inflation will be even more muted as any pick-up in wage costs will depress profit margins rather than raise output prices. Following this logic, from a purely economic standpoint, there would appear to be far greater risks associated with tightening too soon than tightening too late. The flattening of the Phillips Curve means that if tightening were to coincide with some major deflationary shock — and the flaring of the Greece crisis this summer has provided exhibit A of the sort of risks that loom — the Fed would have little way of quickly getting inflation expectations back up again, and deflation could become a real threat. So, given all that: what’s the rush? In short, why not repeat Alan Greenspan’s fast-growth experiment of the 1990s?

There would appear to be three reasons why not, starting with the darker side of the legacy of that experiment: namely, its contribution to two major asset bubbles. It’s important to remember that the Fed is also tasked with maintaining financial stability, and the longer it keeps interest rates at these extraordinarily low levels the greater the possibility for bubbles to form and to burst.

Second, in the same way the Fed would have next-to-no ability to get inflation expectations quickly back up, it would also have almost no way of getting them back down if the Fed was perceived as staying too loose for too long (or “falling behind the curve”) and expectations became unanchored to the upside. Importantly, there is a considerable delay before interest rate hikes trickle through the economy enough to move employment numbers, especially given the flatness of the curve. So, by the time the Fed recognized it had a problem with rising inflation expectations it might be too late to do much about it.

Third, and perhaps most importantly, as long as policy interest rates remain close to the zero lower bound, the Fed has no ammunition to actually deal with a shock. Admittedly the Fed could restart quantitative easing, but we are skeptical that would be particularly effective on its own.
The Fed thus appears to be trying to navigate a very narrow and tricky stretch of road ahead: By starting a gradual rate renormalization process in September, as its latest minutes suggest, the Fed is hoping it can reload the stimulus gun, gently let the air out of asset prices, and keep itself from falling behind the curve on increased inflationary expectations or before a shock hits that could cause deflation to again become a risk… all while operating in an economy that has essentially stripped out the feedback loop between inflation and its policies.

Put that way, September is probably not a moment too soon.

1. Peach, Richard; Rich, Robert; Linder, Henry M. “The Parts Are More Than the Whole: Separating Goods and Services to Predict Core Inflation,” Federal Reserve Bank of New York: Current Issues in Economics and Finance, Volume 17. (2013).
2. Ebenstein, Avraham; Harrison, Ann; McMillan, Margaret, “Why are American Workers getting Poorer? China, Trade and Offshoring”. NBER Working Paper No. 21027, March 2015. nber.org/papers/w21027.
3. Seydl, Joseph; Spittler, Malcolm D, “Did Globalization Flatten the Phillips Curve? US Consumer Price Inflation at the Sectoral Level.” Citi Research: Empirical and Thematic Perspectives, April 2015.

Christopher J Probyn, Ph.D. – Chief Economist – SSGA Economics Team