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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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Both the populist right and the new left are agreed that another long-established principle has bitten the dust… is it a case of The Phillips Curve, R.I.P.?

July 11, 2019

 

ref: - "Ocasio-Cortez, Trump Adviser Unite to Trash the Phillips Curve”, Bloomberg Markets

 

First of all, a quick reminder:

 

The Phillips Curve: A graphic depiction of the inverse relationship between levels of unemployment and wages on the one hand, and inflation on the other. Or in other words, it's a theory that states that the lower the level of unemployment, the higher the level of wages and therefore of inflation (and vice versa).

 

It's one of those theories that sounds totally logical, and with the exception of the period of stagflation in the 1970s has worked pretty consistently for many years… until recently, that is. We talk often about how many economists (most with some degree of faith in the theory of the Phillips Curve) have been flummoxed by the fact that the longest economic expansion in US history, and the lowest unemployment levels for 50 years, have failed to produce any meaningful inflationary pressure.

 

Of course, by now we're pretty well-versed in the factors that have contributed to the stubbornly low inflation numbers that have been defying the wisdom of Prof Phillips that so many subscribed to: technology, changing demographics, low productivity etc. Nevertheless, there has been a widely-held belief, not least amongst policy-setters at central banks, that it was only a matter of time before economic strength would finally begin to boost prices. Not any more… or at the very least, we can now say that some pretty influential figures are modifying their views.

 

Fed Chairman Jay Powell, the most important central banker in the world (much to his President's chagrin), is half-way through his biannual two-day testimony to Congress and yesterday revealed just how much faith in old certainties has been lost. He said that the relationship between unemployment and prices was becoming less relevant and that the economy could sustain much lower rates of unemployment (without succumbing to unwelcome inflation) than previously thought. Just in case anyone missed the point, he said:

 

"The connection between slack in the economy, or the level of unemployment, and inflation was very strong if you go back 50 years. It's gotten weaker and weaker and weaker to the point where it's a faint heartbeat".

 

We wouldn't want to leap to any conclusions prematurely, but that sounds for all the world like the Chairman of the Fed reassessing his remaining commitment to a principle that has underpinned the thinking of monetary policy setters for... well, a very long time.

 

Of course, yesterday Mr Powell was effectively preparing the ground for a rate cut at the end of the month (forget last Friday's stronger-than-expected jobs data, apparently), and the possibility of more to come before year-end. But abandoning adherence to the Phillips curve has a wider significance... it "removes an obstacle that's often raised to policies favoured by progressives (on the left), like a higher minimum wage".

 

In Europe, in the past, we have often been able to smile when we hear Americans talk of lefty politics, in the knowledge that by the standards of most of the rest of the world, the US' two-party political system has represented the views of the right, and the "just-a-little-bit-less" right. But they've got some pretty progressive policies being put forward by some of those vying for the Democratic presidential nomination. If it's hard to imagine the US as a whole ever embracing anything or anybody that could ever be described as genuinely socialist, it's fair to say that more "progressive" thinking is definitely having a sharply increasing influence on mainstream politics.

 

One of those candidates for the Democratic ticket is Alexandria Ocasio-Cortez. AOC (as she is known) is a member of the Democratic Socialists of America and along with the likes of Bernie Sanders does qualify as pretty radically of the Left (by US standards). As it happens, she was also one of those quizzing Jay Powell yesterday. As a firm supporter of lower rates, she gave the Fed Chairman her opinion that the Phillips curve "is no longer describing what is happening in today's economy".

 

In dismissing the Curve theory, for possibly the first and probably the last time AOC found herself with something in common with the Trump administration, whom as we know are vociferous advocates for lower rates on the grounds that the strong economy is NOT provoking inflation (and therefore the Phillips Curve is defunct).

 

Of course, Donald Trump, as a real estate man to his boots (an industry that relies so heavily on cheap debt), will always be biased towards low rates. He has other inappropriate reasons for bawling out the Fed for not cutting rates, like a strong dollar (which is no part of the Fed's remit)... or that Mr Trump measures the success of his presidency by the level of the stock market, just one of the asset classes boosted by the prospect of falling rates.

 

But as Mr Powell prepares us for a cut intended to insure against future and largely global economic headwinds, and questions the validity of the unemployment/inflation relationship, he faces the possibility of an uncomfortable truth: that Mr Trump has been right about one thing all along  --  there's no inflation in the pipeline and rates should be lower. It's, therefore, possible that the Fed might come to the same point of view as those long held by both extremes of the political divide.

 

If that's the case, Mr Powell and his colleagues will be the last of the three to get there... and don't expect the President to be shy in letting him know it.

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