Yellen's recession and that horrible Phillips Curve
The global stock markets are taking yet another beating today and as I am writing this S&P500 is down nearly 3.5% and the latest round of US macroeconomic data shows relatively sharp slowdown in the US economic activity and more and more commentators and market participants are now openly taking about the risk of a US recession in the coming quarters. Obviously part of the story is China, but at the core of this is also is the fact that Fed chair Janet Yellen has been overly eager to interest rates despite the fact that monetary and market indicators have not indicated any need to monetary tightening. It is only the defunct Phillips Curve that could led Yellen to draw the conclusion that monetary tightening is needed in the US. Back in August I wrote:
To Janet Yellen changes in inflation seems to be determined by the amount of slack in the US labour market and if labour market conditions tighten then inflation will rise. This of course is essentially an old-school Phillips curve relationship and a relationship where causality runs from labour market conditions to wage growth and on to inflation. This means that for the Yellen-fed labour market indicators essentially are as important as they were for former Fed chairman Arthur Burns in the 1970s and that could turn into a real problem for US monetary policy going forward. ...Central banks temporary can impact real variables such as unemployment or real GDP, but it cannot permanently impact these variables. Similarly there might be a short-term correlation between real variables and nominal variables such as a correlation between nominal wage growth (or inflation) and unemployment (or the output gap). However, inflation or the growth of nominal income is not determined by real factors in the longer-term (and maybe not even in the short-term), but rather than by monetary factors – the balance between demand and supply of money. The Yellen-fed seems to be questioning Friedman’s fundamental insight. Instead the Yellen-Fed seems to think of inflation/deflation as a result of the amount of “slack” in the economy and the Yellen-fed is therefore preoccupied with measuring this “slack” and this is what now seems to be leading Yellen & Co. to conclude it is time to tighten US monetary conditions. This is of course the Phillips curve interpretation of the US economy – there has been steady job growth and unemployment is low so inflation most be set to rise no matter what nominal variables are indicating and not matter what market expectations are. Therefore, Yellen (likely) has concluded that a rate hike soon is warranted in the US. This certainly is unfortunately. Instead of focusing on the labour market Janet Yellen should instead pay a lot more attention to the development in nominal variables and to the expectations about these variables. ...If we look at nominal variables – the price level, NGDP, the money supply and nominal wages – the conclusion is rather clear. The Fed has actually since 2009 delivered a remarkable level of nominal stability in terms of keeping nominal variables very close to the post-2009 trend. If we want to think about the Bernanke-Fed the Fed had one of the following targets: 1.5% core PCE level targeting, 4% NGDP level targeting, 7% M2-level targeting or 2% wage level targeting at least after the summer of 2009. However, the Yellen-Fed seems to be focusing on real variables – and particularly labour market variables – instead. This is apparently leading Janet Yellen to conclude that monetary conditions should be tightened. However, nominal variables are telling a different story – it seems like monetary conditions have become slightly too tight within the past 6-12 months and therefore the Fed needs to communicate that it will not hike interest rates in September if it wants to keep nominal variables on their post-2009 path. Obviously the Fed cannot necessarily hit more than one nominal variable at the time so the fact that it has kept at least four nominal variables on track in the past 5-6 years is quite remarkable. However, the Fed needs to chose one nominal target and particularly needs to give up the foolish focus on labour market conditions and instead fully commit to a nominal target. My preferred target would certainly be a 4% (or 5%) Nominal GDP level target. And Chair Yellen, please lay the Phillips curve to rest if you want to avoid sending the US economy into recession in 2016!Obviously Yellen did not get the memo and now we are exactly risking that recession that I warned about in August. And no I am not bragging about my ability to forecast. In fact I am doing the exact opposite. In August the markets were telling us that there was no inflationary pressures (and I was only repeating that), but Yellen has all along insisted that the market expectations about inflation were wrong and that the Phillips Curve was right. That might turn out to be a costly mistake.