The inflation bogeyman and the Fed reaction function

By Edward Harrison On Apr 9, 2021

Listen, the big news today is that, yesterday, I got the first shot of a two-shot Pfizer COVID-19 vaccination dose. I feel well less than 100% today to be honest. But my spirits are good. The next appointment is in three weeks. Within a couple of weeks, my mom, my sister, my wife and I can all interact like normal people again without fear of infecting my 91-year old mother. I had to lead with that because it’s a personal anecdote that tells you how palpably close we are to a full re-opening in the US.

But as we re-open there are a few problems to consider. One of those is inflation. Today, we got the latest producer price index figures. And they were well above expectations, showing a seasonally-adjusted 1.0% rise in the prices producers of final goods paid for their ‘inputs’. And, on a year-over-year basis, this puts us up to 4.2%, the highest level in quite some time.

What should we make of these numbers? And what should and will the Federal Reserve make of the numbers? I have some thoughts on this, which are the subject of this post.

The Phillips Curve

Before I get into how to think about the Fed’s reaction function, let’s talk about how the Fed has reacted to this stuff in the past. And to do that we have to introduce two concepts, NAIRU and the Phillips Curve.

NAIRU is the acronym for the so-called non-accelerating inflation rate of unemployment. You may not be familiar with this term. But it has been at the heart of economics and monetary policy for at least the last four decades. For example, I learned about it at University in the 1980s. But here’s what we were told.

They told us that lower unemployment is a great thing. More people with jobs and lower unemployment is what you want for any economy to do well. But, in any market-based economy, as people’s needs and businesses change, there are always people leaving jobs or starting new jobs. Some of this results in people being let go before they can find new employment. And, for that reason we were told that at all times having some people unemployed on the sidelines despite their willingness to work is basically unavoidable. That’s frictional unemployment.

Here’s the thing. If frictional unemployment is a given, you can never really have zero percent unemployment. If you did, the competition for labor would be so fierce you would see wages bid up at a phenomenal rate. And if wages were being bid up everywhere, you’d see those cost pressures passed through from producers and businesses to consumers. In essence, we would get higher inflation. And while low levels of inflation, say 2%, are easy to deal with, 10% inflation is a nightmare for businesses and it eventually hurts the economy. So, central banks, having interest rates as a policy tool, will work to stop inflation as soon as they can by raising interest rates.

This whole edifice of thinking is based on the Phillips Curve, described in Wikipedia as follows:

The Phillips curve is a single-equation economic model, named after William Phillips, describing an inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of wage rises. Phillips did not himself state there was any relationship between employment and inflation; this notion was a trivial deduction from his statistical findings. Samuelson and Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place. In so doing, Friedman was to successfully predict the imminent collapse of Phillips’ a-theoretic correlation.

While there is a short run tradeoff between unemployment and inflation, it has not been observed in the long run. In 1967 and 1968, Friedman and Phelps asserted that the Phillips curve was only applicable in the short-run and that, in the long-run, inflationary policies would not decrease unemployment. Friedman then correctly predicted that in the 1973–75 recession, both inflation and unemployment would increase. The long-run Phillips curve is now seen as a vertical line at the natural rate of unemployment, where the rate of inflation has no effect on unemployment. In the 2010s the slope of the Phillips curve appears to have declined and there has been controversy over the usefulness of the Phillips curve in predicting inflation. Nonetheless, the Phillips curve remains the primary framework for understanding and forecasting inflation used in central banks.

The New Paradigm

If you read between the lines of the Wikipedia entry, it’s clear there is considerable doubt about the Phillips Curve as a framework. After all, the notion of raising interest rates to slow the economy to keep inflation at bay is a bit perverse since you are basically creating unemployment. The goal of the policy is to make sure unemployment rates never get so low that they causes inflation to rise. So, you raise rates preemptively enough such that ostensibly enough people lose their jobs to keep wage pressures at bay.

Now, not only is this perverse because you are creating unemployment, it is also perverse because it effectively kneecaps wage earners at the tail end of every business cycle. Just as wages are beginning to rise and the middle class is beginning to feel the benefits in their pocket book – boom – rates rise and the economy lapses into recession.

As income and wealth inequality has risen during the last four decades this policy has been in place, there have been increasing cries to restrict it. From Fed Chair Alan Greenspan through to Bernanke, Yellen and Powell we have seen lower and lower levels of unemployment with lower inflationary pressures than the Phillips Curve model would have told you. Fed Chairman Powell has basically said they are putting the Phillips Curve aside for now then. The new paradigm is one in which unemployment is more the primary goal for the Fed than inflation in their dual mandate. And if that means letting the economy run hot, letting inflation rise, then so be it.

The inflation bogeyman

This paradigm shift sets the Fed up for a reckoning with the bond vigilantes. Basically, bond market participants are in the process of testing whether the Fed’s reaction function is actually as dovish as they claim it is. Many people in the bond market think that, when push comes to shove and inflation rises, the Fed will throw in the towel on wages and employment and start to tighten monetary policy. This latest PPI report is the first in a potential line of numbers that will test the Fed’s resolve.

What we’re seeing now with inflation has two questions surrounding it. And both will be resolved after the full-reopening of the economy later this year. The first issue is about supply shocks. I totalled my main road bike last weekend running into a low garage overhang while the bike was strapped to the roof of my car. After my anger and sadness subsided and I started looking for a new bike, I realized there weren’t any. Supply chains are all screwed up and parts are back ordered. Plus everyone wants a bike these days because of the pandemic. I was lucky to find something. But my situation highlights the problem.

Just this morning, GM said it will halt production at several North American plants because it can’t get the semiconductor chips it needs for the computerized parts of their cars. They’re effectively rationing production instead of raising prices. But, the “average new-vehicle incentive fell nearly $1,000 last month compared with a year earlier, to about $3,500”. So, effectively, they are raising prices too.

The question goes to how long this lasts? Once the pandemic is over, we assume these price pressures will subside. But will they? We don’t now.

Then there is the deflationary episode of the lockdown. When we compare today’s prices to last year’s prices, that full scale global lockdown is a big distortion. It’s going to make prices today look a lot higher as a result. And so, everyone is ready to discount the inflation figures that are going to come out in the next few months for just this reason. Nevertheless, when the easy comps are over, we’ll back to normal. If inflation is still elevated then, the Fed (and other central banks) will have a decision to make.

What today’s PPI means

So, if you look at the PPI number today in this context, I think it’s significant. I wrote a thread on Twitter about it you should follow. The gist is this:

Producer price pressures have risen at the end of every business cycle over the last 40 years.
That rise has coincided with Fed tightening in the form of interest rate hikes.
I would say that, in the past, the Fed has seen the PPI numbers and decided to pre-empt a passthrough to consumer prices by raising rates.
What makes this cycle unique is that the rise in producer prices is happening at the beginning of the cycle and the Fed is NOT tightening as that rise occurs.

It’s not clear to me what the Fed will do. They say they won’t tighten. But they told us in the last rate cycle that 2% inflation wasn’t a ceiling, it was a target. And yet, after missing that target for some 5 years or more, the Fed went and hiked rates right up until we almost had a recession. They were forced to back off the rate hikes in late 2018 after the credit cycle turned down demonstrably and equities fell almost 20 percent. We were very close to recession. But the Fed cut rates and eventually the pandemic took over.

If I had to predict what the Fed will actually do, I wouldn’t necessarily believe they would stick to their forward guidance simply because they didn’t in the last cycle just three or four years ago, They say we are in a new paradigm. But the proof is in the pudding.

I don’t think any of this is extraordinarily urgent because we still have the free pass for the lockdown comps to get through. But by July and August, we will be through that period and inflation reads will start to matter again. Let’s see what the Fed does then.