Fed chairman and the Phillips curve

 

On July 11, 2019 before the Senate Banking Committee, the Federal Reserve Board Chairman Jerome Powell said that the relationship between unemployment and inflation in the US has vanished. According to Powell,

“The relationship between the slack in the economy or unemployment and inflation was a strong one 50 years ago … and has gone away,” … the strong tie between unemployment and inflation was broken at least 20 years ago and the relationship “has become weaker and weaker and weaker.”

It is a well-known belief that by means of monetary policy, the central bank can influence the rate of real economic expansion. It is also held that this influence carries a price, which manifests itself in terms of inflation. For instance, if the goal is to reach faster economic growth rate and a lower unemployment rate then citizens should be ready to pay a price for this in terms of a higher inflation rate.

 

It is held that there is a trade-off between inflation and unemployment, which is depicted by the Phillips curve. (William Phillips described a historical relationship between the rates of unemployment and the corresponding rates of rises in wages in the United Kingdom,1861-1957, published in the quarterly journal of Economica,1958).

 

The inverse correlation between the inflation rate and the unemployment rate has become an important element in the mainstream theory of inflation. The lower the unemployment rate the higher the inflation rate. Conversely, the higher the unemployment rate the lower the inflation rate is going to be, so it is held.

 

Can we ascertain the facts of reality in Economics by means of correlations?

It is generally held that by means of statistical and mathematical methods one can organize historical data into a useful body of information, which in turn can serve as the basis for the assessments of the state of the economy. It is also held that the knowledge secured from the assessment of the data is likely to be of a tentative nature since it is not possible to know the true nature of the facts of reality.

 

Some thinkers such as Milton Friedman held that since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. On this way of thinking, what matters is that the theory can yield good predictions. According to Friedman,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.[1]

For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Based on this view he forms a model, which is then validated by means of statistical methods. The model is then employed in the assessments of the future direction of consumer spending.

 

If the model fails to produce accurate forecasts, it is either replaced, or modified by adding some other explanatory variables. What matters here is how well consumer outlays are correlated with various variables in order to secure a good predictive model. In this sense, all that an economist requires is to establish a good fit between the dependent variable and various other variables.

 

On this way of thinking, we form our view regarding the real world based on how well the various pieces of information are correlated with each other. Observe however, that by establishing a good fit between personal consumer outlays and various other pieces of information one does not really explain the nature of consumer outlays, one just describes things.

 

By establishing that changes in consumer outlays are well correlated with changes of other data, one says nothing about the nature of things. This type of information does not tell us much regarding the underlying cause and effect. The fact that good correlation was established between consumer outlays and disposable income does not imply that outlays are caused by disposable income. It is quite possible that one could also find very good correlation with some other variable. Does this then imply that the other variable is the cause of consumer outlays?

 

Likewise, by stating that unemployment is inversely correlated with inflation does not establish the cause of inflation. It only describes that during a particular period unemployment and inflation had an inverse correlation.

 

Using statistical correlation as the basis of a theory means that “anything goes.” For example, let us assume that a high correlation has been found between the income of Mr. Jones and the rate of growth in the consumer price index. The higher the rate of increase of Mr. Jones’ income, the higher the rate of increase in the consumer price index. Therefore, we could easily conclude that in order to exercise control over the inflation rate the central bank must carefully watch and control the rate of increases in Mr. Jones’ income. This example is no more absurd than the Phillips curve framework.

 

Theory must precede the data to make sense of the data

To make sense of the data we must have a theory, which stands on its own feet, and did not originate from the data. The heart of such a theory is that it must originate from something real that cannot be refuted. For instance, a theory that rests on the foundation that human beings are acting consciously and purposefully complies with this requirement.

 

The statement that human beings are acting consciously and purposefully cannot be refuted, for anyone that tries to do this, does it consciously and purposefully i.e. he contradicts himself. (He consciously sets a goal to refute that human beings act consciously and purposefully).

Ludwig von Mises, the founder of this approach labelled it praxeology. Using the knowledge that human beings are acting consciously and purposefully, Mises was able to derive the entire body of economics.

Consequently, Mises concluded that contrary to the natural sciences where the true causes are not known to us in economics the knowledge that human beings are acting consciously and purposely permits us to ascertain what the underlying true causes are. On this way of thinking the causes emanate from human beings themselves. According to Mises,

The physicist does not know what electricity “is”. He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process.[2]

Also on this Rothbard said,

One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was in looking at Grand Central Station behavior during rush hour. The “objective” or “truly scientific” behaviorist, he pointed out, would observe the empirical events: e.g., people rushing back and forth, aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see the purpose is to get from home to the train to work in the morning, the opposite at night, etc. It is obvious which one would discover and know more about human behavior, and therefore which one would be the genuine “scientist”.[3]

 

Economic activity and inflation

Contrary to mainstream thinking, strong economic activity as such does not cause a general rise in the prices of goods and services and economic overheating labeled as inflation. Regardless of the rate of unemployment, as long as every increase in expenditure is supported by production no overheating can occur.

 

The overheating emerges once expenditure rises without the backup of production – for instance, when the money stock is increasing. Once money increases it generates an exchange of nothing for something, or consumption without preceding production, which leads to the erosion of real wealth.

 

As a rule, increases in the money stock are followed by rises in the prices of goods and services. Prices are another name for the amount of money that people spend on goods they buy. If the amount of money in an economy increases while the amount of goods remains unchanged more money will be spend on the given amount of goods i.e., prices will increase, all other thing being equal.

 

Conversely, if the stock of money remains unchanged, it is not possible to spend more on all the goods and services; hence no general rise in prices is possible, all other things being equal. By the same logic, in a growing economy with a growing amount of goods and an unchanged money stock, prices will fall.

 

The Fed follows further fallacies

Furthermore, in his Senate Banking Committee speech the Fed chair Powell also said,

“In additional to that, we are learning that the neutral interest rate is lower than we had thought … So monetary policy hasn’t been as accommodative as we had thought,”

The neutral rate is associated with the state of equilibrium of the economy. According to this view, in order to establish whether monetary policy is tight or loose it is not sufficient to focus only on the level of money market interest rates; rather one also needs to compare money market interest rates with the neutral rate. Thus if the market interest rate is above the neutral rate then the policy stance is tight. Conversely, if the market rate is below the neutral rate then the policy stance is loose.

 

Thus, when the Fed chair argues that the neutral interest rate is much lower than Fed officials held this implies that the current federal funds rate target is too high. (The federal funds rate on this way of thinking is above the neutral rate). This means that there is a rationale to lower the federal funds rate target to bring the economy onto a growth path of equilibrium.

 

Note that on this way of thinking the Fed is trying to justify the lowering of the interest rate target thus setting in motion a further misallocation of scarce real wealth. Needless to say that this will further reinforce the process of economic impoverishment.

 

Summary and conclusions

The Fed Chairman’s suggestion that the inverse correlation between inflation and unemployment has disappeared reveals that US central bank policy makers were previously employing a bankrupt theoretical framework to navigate the economy. As a result, Federal Reserve’s policies have severely undermined the process of real wealth formation thereby contributing to economic impoverishment.

 

[1] Milton Friedman, Essays in Positive Economics, Chicago: University of Chicago Press, 1953.

 

[2] Ludwig von Mises, Human Action p 355.

[3] Murray N. Rothbard preface in Theory and History by Ludwig von Mises.