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John Maynard Keynes once wrote, “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
Truer words were never spoken, although if you updated Keynes today, the quote would begin with “practical women” to take account of Fed Chair Janet Yellen. The “defunct economist” in question would be William Phillips, inventor of the Phillips curve, who died in 1975.
In its simplest form, the Phillips curve is a single-equation model that describes an inverse relationship between inflation and unemployment. As unemployment declines, inflation goes up, and vice versa. The equation was put forward in an academic paper in 1958 and was considered a useful guide to policy in the 1960s and early 1970s.
By the mid-1970s the Phillips curve broke down. The U.S. had high unemployment and high inflation at the same time, something called “stagflation.” Milton Friedman advanced the idea that the Phillips curve could only be valid in the short run because inflation in the long run is always determined by money supply.
Economists began to tweak the original equation to add factors — some of which were not empirical at all but model-based. It became a mess of models based on models, none of which bore any particular relationship to reality. By the early 1980s, the Phillips curve was no longer taken seriously even by academics and seemed buried once and for all. RIP.
But like a zombie from The Walking Dead, the Phillips curve is baaaack!
And the person who has done the most to revive it is none other than Janet Yellen, the 70-year-old liberal labor economist who also happens to be chair of the Federal Reserve.
Unemployment in the U.S. today is 4.3%, the lowest rate since the early 2000s. Yellen assumes this must result in inflation as scarce labor demands a pay raise and the economy pushes up against the limits of real growth. Yellen also agrees with Friedman that monetary policy works with a lag.
If you believe that inflation is coming soon and that policy works with a lag, you better raise interest rates now to keep the inflation from getting out of control. That’s exactly what Yellen and her colleagues have been doing.
Meanwhile, back in the real world, all signs point not to inflation but to deflation. Oil prices are declining, intermediate-term interest rates are falling, labor force participation is falling, demographics favor saving over spending and logistics and supply-chain giants like Wal-Mart and Amazon are relentlessly squashing price increases wherever they appear.
Even traditional high-price sectors like college tuition and health care have been cooling off …read more
Source:: Daily Reckoning feed
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