A Subversive at the Fed Proves Destroying Jobs is Not the Answer

“Doubts Arise on Growth-Inflation Link.” The Wall Street Journal headline caught our attention not because it was news, but because it was 40 years out of date. It was way back in the 1980s that Ronald Reagan smashed for all time the Phillips Curve myth that too many people working causes inflation.

Get out your magnifying glass and squint real hard and you may be able to detect the occasional inverse correlation between the first graph below, of inflation over the past 42 years, and the second of the unemployment rate over the same period. But the real story of the graphs is that inflation first subsided and then remained astonishingly stable during 40 years of vigorous economic growth. During the steepest drop in unemployment, from late 2011 till the onset of the pandemic in 2019, inflation remained essentially flat, between 2.0 and 2.5%.

“Sticky” CPI 1980 – 2022

Unemployment Rate 1980 – 2022

Still, we can’t be too hard on the WSJ headline writers. Despite overwhelming empirical evidence that economic growth and full employment growth heal inflation rather than inflame it, some amazingly large portion of the economic establishment still either believes in “the link” or acts as if it does. Most econometric models use some version of the Phillips Curve to forecast inflation. The Fed, of course, must cling to the link; to concede the point would be to concede its irrelevance to its statutory mission of balancing price stability with full employment.

All the more gratifying to learn from WSJ author Nick Timiraos that the latest powerful dissent from the orthodoxy comes from the Fed itself. Austan Goolsbee, president of the Chicago Federal Reserve Bank, destroys the employment-inflation “link” as an explanation for post-pandemic price increases.

He begins by pointing out how badly the traditional assumptions have performed so far. In the graphs below, the blue line shows the expected behavior when the Fed reacts to a surge in inflation with its typical tools. The red line shows what happened this time around.

Reading the graphs backward from right to left, the graph of core PCI inflation shows that although typically inflation has lots of momentum even in the face of Fed responses, this time around it slowed much more quickly. The Fed did not start raising the Fed Funds rate until March 2022. By that time the rate of increase in Core PCE Inflation was already slowing. By early 2023 it had begun to fall, contrary to historical experience by which it would have continued to rise steeply into late 2024.

The first, leftmost graph shows another anomaly. GDP started to fall before the Fed started raising rates. Then in late 2022, just as the Fed began its rate hikes, GDP first leveled off and soon began a modest recovery. The graph ends too soon to take Q3 into account, which would add to the anomaly as GDP rose at an astonishing 4.9% annualized.

The middle graph is the most remarkable, and to supply-siders most gratifying. In the face of 11 consecutive rate hikes, boosting rates by some five points, employment soared even while, as the third graph already showed, inflation was declining.

More people, doing more work, producing more goods and services, do not cause inflation. Neither does paying them in accord with what they produce.

For Goolsbee, the anomalies demand an alternative account of the 2021-23 inflation, one that has little to do with Fed policy. He argues that the “most important factors were Covid-related,” including “well documented negative supply chain shocks and unusual shifts in the composition of demand.” Adding to these “supply-side difficulties, Covid reduced labor supply as labor force participation—especially for women and those nearing retirement—dropped.”

Supporting the supply-side view, Goolsbee cites research showing that the rate of price increases varied across “a wide range of industries,” suggesting idiosyncratic causes rather than a systemic decline in the value of the dollar. Moreover, “the biggest price increases” were “associated with the smallest increases in quantity [supplied], fully consistent with the role of supply shocks as an important driver of overall inflation.” He cited the Chicago Fed’s own model, as well as recent research including a paper co-authored by former Fed Chairman Ben Bernanke, as further evidence for the supply side explanation.

As to why inflation has moderated, Goolsbee argues that the Fed, so far, has been largely irrelevant. The better explanation is that “negative supply shocks and demand distortions have been unwinding steadily” and “supply chains have improved considerably… and that improvement is likely to continue working its way through the economy.”

One welcome development for longer term growth is a recovery “in labor supply… the prime-age labor force participation rate is at its highest level since 2001.” He speculates that “perhaps because of more flexible post-Covid work arrangements, the female labor force participation rate is hitting record highs, as is the participation rate for those with disabilities.”

As for the Fed, he argues that though it has done little good so far, it may yet do great harm. Sticking to the usual assumptions about what “growth and labor market conditions mean for inflation… is a recipe for overshooting and causing an unnecessary downturn.”

In particular, he urges his colleagues not to “obsess over the near-term path for real wages,” nor assume “that a tight labor market with wages rising faster than prices would result in a wage–price spiral.” Because near-term wages generally are stickier than prices, “labor costs [are] a lagging indicator of inflation.” Using wage growth “to predict inflation” and make “monetary policy decisions… would almost certainly mean overshooting.”

The Fed’s determination to put Americans out of work is the more vicious given its irrelevance. It should stop.

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