Is the Fed late in hiking? Is the Phillips Curve still alive in this millenium, aging ‘baby-boom’ generation?

“In our view, the US economy has now reached full employment and is likely to overshoot meaningfully, a path that has often proven risky. From this perspective, the case for further tightening is strong.” Yes, these are statements you typically see in an IB research notes or even from central bankers such as BoJ’s Harada who said at 1 Jun 2017, “inflation to pick up as jobless rate approaches 2%”.

Central banks conduct monetary policies to achieve low and stable inflation (or avoid deflation, CPI<0, where investment expectations from surveys are poor, hoarding of reserves for a more opportunistic time results in CAPEX YoY flattening) and have, over the years, expanded their tools to manage financial stability and volatile exchange rates. Typically,  countries develops a framework to enable the central bank to target short-term interest rates. When monetary transmission mechanism is developed, open market operations is effecive in steering short term interest rates, which in turn influence longer term rates and overall economic activity. A fully flexible exchange rate regime supports a wide range of independent, domestic monetary policies and an effective inflation targeting framework. Of course, the autonomy of central banks to implement their macroprudential frameworks and corperation with international committees to have the capacity to curb systemic risk and negative externalities is well placed.

Why is deflation bad for everyone? 

CAPEX from upstream to downstream of the supply chain is tighten significantly on each passing. This leads to no or little revenue for smaller firms at the downstream. Headcounts are cut despite ongoing family commitments. Families are tighther on letting cash out of pockets. This further puts pressure on upstream bottom line despite ongoing commitments to constantly innovate and outcompete rivals and attract new customers. This vicious cycle stagnates money flow and further exaceberates unemployment. (Yes, targeting higher inflation is no different from targeting lower unemployment or higher velocity of money supply) That’s why lower inflation equates to higher employment (not a chicken or egg, but in tandem from weaker espectations, less spending, less investments) If there is no intervention from the central bank to prop up citizens’ spending, existing borrowers, who are unemployed, would turn non-performing loans into higher cumulative bad debts and translates to equity absorbing losses in banks balance sheets. Retail deposits being the most stable capital reserve might run out and lead to systemic devaluations across asset classes and affect the economy further given banks or FI are counterparties to everyone when it concerns money. In such states, financial intermediaries with its capital locked up, will be least able to be financiers to growing SMEs that could halt this vicious cycle by creating new jobs and restructure the economy’s workforce. Think of Japan since 1989, for an example.

Note: CPI does not include housing prices, but uses rents as a proxy, which was argued to be misleading as in low rates environment, housing prices can rise but if there is high vacency, rental prices can be dropping. This was why it did not warn a housing asset bubble in 2006. 

That’s why Core PCE deflator is the preferred Fed measure of inflation rate.

In contrast, the Fed has chosen to focus in recent years on the personal consumption expenditure (PCE) deflator, which is a less-known but more comprehensive price measure.

It puts prices on everything that the government statistics agencies consider “consumer spending,” including plenty of items that are paid for by other entities (health care paid for by insurance companies or by government programs such as Medicare and Medicaid, for example), as well as a number of items for which explicit prices do not even exist (the cost of financial services that banks extract by maintaining a gap between savings and borrowing rates, for example).

When evaluating the rate of inflation, Federal Reserve policymakers also take the following steps.

  • First, because inflation numbers can vary erratically from month to month, policymakers generally consider average inflation over longer periods of time, ranging from a few months to a year or longer.
  • Second, policymakers routinely examine the subcategories that make up a broad price index to help determine if a rise in inflation can be attributed to price changes that are likely to be temporary or unique events. Since the Fed’s policy works with a lag, it must make policy based on its best forecast of inflation. Therefore, the Fed must try to determine if an inflation development is likely to persist or not.
  • Finally, policymakers examine a variety of “core” inflation measures to help identify inflation trends. The most common type of core inflation measures excludes items that tend to go up and down in price dramatically or often, like food and energy items. For those items, a large price change in one period does not necessarily tend to be followed by another large change in the same direction in the following period. Although food and energy make up an important part of the budget for most households–and policymakers ultimately seek to stabilize overall consumer prices–core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.

The difference between CPI and PCE are:

  • PCE price index is based on the Fisher-Ideal formula, while the CPI is based on a modified Laspeyres formula
  • CPI prices and weightings are based on household surveys and PCE is based on business surveys i.e. CPI contains a large component of owner-equivalent rent, which by definition is an imputed value and not a real direct expenditure
  • CPI is a practical alternative used to give a quicker read on prices in the previous month. PCE is typically revised three times in each of the months following the end of a quarter, and then the entire NIPA tables are re-based annually and every five years
  • The “net” scope effect adjusts for CPI items out-of-scope of the PCE price index less items in the PCE price index that are out-of-scope of the CPI. For example, CPI measures only the out-of-pocket healthcare costs of households where PCE includes healthcare purchased on behalf of households by third parties, including employer-provided health insurance

Hence, CPI, PPI and retails sales YoY take the back stage. Yet, various indexes can send diverse signals about inflation. A good understanding of which component in these inflation measures that’s proping up inflation does clarify the big picture. Look here for more details on the breakdown. (A side digression.. a more accurate measurement of time series macroeconomic data would be chain-type aka Fisher indexes that allow for the effects of changes in relative prices and in the composition of output over time, thereby eliminating a major source of bias in the previously featured fixed-weighted, or Laspeyres, measures of real output and prices)

After GFC, monetary policies were eased such that short term rates came close to zero which limited the option to cut policy rates further. With the danger of deflation rising, central banks took unconventional policies such as BoJ targeting the yield curve slope instead of inflation level, while ECB experimented an unprecedented policy of negative short term rates. Meanwhilem this came as a time for criticising the failure of inflation targeting to prevent the occurence of GFC because it focused too much on the stabilisation of inflation volatility and too little on financial developments such as the rapid increase in house prices and FI leverage ratios prior to GFC. Subsequently, despite a persistently low short term rate, it failed to speed up recovery in economic activity and inflation. Eventually, the first time bets that short term rates will rise with a rate hike by the central bank given a pick up in inflation went wrong for fixed income desk was the divergence of Taylor rule baseline expectations and the FFTR midpoint. So,

Taylor rule used to work before GFC as a timely tool for central bankers to turn hawish or dovish when the economy is deem to be ripe and ready for a change in rates.

Taylor Rule: the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual GDP from potential GDP

short-term nominal rate = GDP Deflator + long run equilibrium rate +B1(GDP Deflator – inflation target) + B2[ log(real GDP) – log(potential output) ]

However, in contemporary economics, the central bank does not need to take fluctuations in the output gap into account when setting interest rates aka B2 = 0

Asset bubble averse economist suggests Taylor rule to include targeting more factors such as equity market cap, net wealth of the country (including illiquid assets, where net value is hard to measure e.g. housing prices), or rates spread (aka yield curve slope)


However, the Federal reserve delayed for a long resulting in a late hike, just when the cycle us starting to turn down. Now, given Trump’s promise of 3% growth, any change in near term dot plots to a majority below median would widen the divergence between the Taylor Rule baseline expectation and FFTR. If we confirm with the Fed’s own Labour Market Conditions index, we are indeed hiking at the end of a labour cycle. That said, now it depends on the Fiscal side of policy to do the heavy lifting and create the needed employment and economic growth, otherwise, both the Fed and president will be blamed culprits for the next recession.

labor market conditions index

Meanwhile, the reason for this delay in hike by the Fed could be a result of a flat Philips Curve. As shown below, Core PCE (Fisher index) is in contandem with markets expectations of inflation (Nomimal bond yield – TIPS yield… might deviate but bounded, if bonds are trading away from par (liquidity premium.. wider deviation for shorter term) and changes in financing cost for holding bonds)



Phillips Curve, suggested that government could reduce the unemployment rate by creating a more rapid rate of inflation of wages and prices. However, Friedman and Phelps argued that the government could not permanently trade higher inflation for lower unemployment. In other words, policymakers can target low inflation rates or low unemployment, but not both. Imagine that unemployment is at the natural rate. The real wage is constant: workers who expect a given rate of price inflation insist that their wages increase at the same rate to prevent the erosion of their purchasing power. Now, imagine that the government uses expansionary monetary or fiscal policy in an attempt to lower unemployment below its natural rate. The resulting increase in demand encourages firms to raise their prices faster than workers had anticipated. With higher revenues, firms are willing to employ more workers at the old wage rates and even to raise those rates somewhat. For a short time, workers suffer from what economists call money illusion: they see that their money wages have risen and willingly supply more labor. Thus, the unemployment rate falls. They do not realize right away that their purchasing power has fallen because prices have risen more rapidly than they expected. But, over time, as workers come to anticipate higher rates of price inflation, they supply less labor and insist on increases in wages that keep up with inflation. The real wage is restored to its old level, and the unemployment rate returns to the natural rate. But the price inflation and wage inflation brought on by expansionary policies continue at the new, higher rates.

Looking at the chart below, unemployment U3 did return to pre GFC rate, but the long period of low rates had inflated the real wage (Base pre-GFC = 100) to be 5% higher than before the GFC. However, a higher purchasing power didn’t seem to boost persistently low PCE until 2016.

real wage.png

Friedman’s and Phelps’s analyses provide a distinction between the “short-run” and “long-run” Phillips curves.

So long as the average rate of inflation remains fairly constant, as it did in the 1960s, inflation and unemployment will be inversely related. 

The long-run Phillips curve could be shown as a vertical line above the natural rate shown below.

The Phillips Curve, 1961–1969


These long-run and short-run relations can be combined in a single “expectations-augmented” Phillips curve. The more quickly workers’ expectations of price inflation adapt to changes in the actual rate of inflation, the more quickly unemployment will return to the natural rate, and the less successful the government will be in reducing unemployment through monetary and fiscal policies.

1. Current unemployment is still above the ‘natural’ rate and there is still some slack to close as seen from log(actual GDP/potential GDP) still lower than zero.

There is some rate of unemployment that, if maintained, would be compatible with a stable rate of inflation. Its called “nonaccelerating inflation rate of unemployment” (NAIRU) because, unlike the term “natural rate,” NAIRU does not suggest that an unemployment rate is socially optimal, unchanging, or impervious to policy. A simple estimate of NAIRU would be the rate of unemployment for which the change in inflation rate (accleration of prices) = 0.

pce 2.png

From my calculations shown below, NAIRU since GFC is 9.05% whereas pre GFC NAIRU was 5.87%. Yes, the Expectations-Augmented Phillips Curve has been flat since 2007 and that resulted in an unreliable NAIRU post GFC. Hence we use the FRED NAIRU.

nairu newnairu old

Janet Yellen would be right to argue that the flat Philip Curve is short term and temporary as we see from history that whenever current unemployment is below the short term NAIRU, inflation picks up as shown below.

nairu FRED.png

Before July 2016, the 5y5y forward inflation expectation rate is falling in tandem with the short term NAIRU since 2011. As this expectation falls, the intercept for the Phillips curve shifts down and pulls the curve inward. This shift could be another potential cause of the seemingly flat Phillips curve.

However, ever since current unemployment went below NAIRU at 4.9%, inflation expectations went up. This was further exceberated with Trump’s election victory and promised tax cuts (more growth in CAPEX) and bringing jobs back to U.S. If this trend continues, which Fed Chairwoman Yellen is betting on, PCE would pick up further. Yes, you may ask, why in 1997, despite below NAIRU, PCE still drop sharply?

2. Declining working age population is disinflationary

Aging population and declining working population is a disinflationary force in any economy as any citizen would be tighten any out of pocket outlay if there is any inflow. Talking on deflation, we don’t have to look further than Japan for a good example. Japan has long been a opponent of the idea of bringing in immigrants to fill up the labour gap.

In a study named “Aging and the Economy: The Japanese Experience“, the authors said that aging is deflationary when caused by an increase in longevity but inflationary when caused by a decline in birth rates. A falling birth rate implies a smaller tax base, which might prompt the government to allow the inflation rate to rise in order to erode its debt and stay solvent. In contrast, increased longevity causes the ranks of pensioners to swell and their political power to increase, leading to tighter monetary policy to prevent inflation from eroding savings. Using a model, the authors concluded that the deflationary effect of higher longevity dominates.

Looking at the charts below, a spike in working age population in Japan always hint a higher Core CPI in the near future. Look at Japan’s Core CPI dipping and staying below 2% since its working age population YoY went below 0% and reach an inflexion point in their working age population.

working popul japan

And this is not a Japan problem, but a millenium generation problem that is not engaging in increasing the fertility rate of their country. Korea, Europe, U.S. and Canada also face the same shortage of working age population covering the aging population. The alarming sign from this chart is that YoY growth in US primt age working population has dipped below 0, and this pose a danger to Trump’s way of growth by bringing back manufacturing jobs back to U.S.

working popul

However, recently in Jan 2017, Japan loosen immigration policies for highliy skilled foreign workers (using some point system as eligibility). So this is a good sign of higher CPI for Japan.

This results in inflation being not nudging higher, despite corporates committing more CAPEX and reducing the slack in the economy with a rise in growth of real wages. We are still in a stage where there is still a small slack in the economy, but have pretty much closed the gap since GFC. Note that real wage growth is very ‘sticky’ and hover between -2.50% and +2.50% YoY.


But how is demographics linked to inflation? 

Economic growth = labor productivity + YoY growth in the number of hours worked

Expanding the latter is difficult if there is no population growth among the working age or prime age population. This means economic growth is more or less effectively reduced to the growth in labor productivity.

Looking at the chart below, YoY growth in hours worked is declining whereas YoY growth in GDP is prop up along with a higher YoY growth in real output.


3. Wages are ‘sticky’ and people are more likely to hoard money then spend

Monetary Base * Money Velocity = Inflation Rate * GDP

Assuming constant velocity,

Inflation Rate (YoY%) = Money Growth (YoY%) – Real GDP Growth (YoY%)

The broadest definition of money (MZM) has a velocity of 1.3 is strong evidence of hoarding of money (i.e. save more, spend less). Green line is the inflation rate if one were to follow the definition of “quantity theory of money”, which is moving in tandem with Core PCE YoY.

velocity 3velocity

Despite QE3 on 12 Sep 2012, which resulted in the Fed’s balance sheet exploding to $2.8 trillion, YoY change in M1,M2,MZM money stocks have not been increasing. However, ever since yields picked up in mid 2016, money stock have seen growth as it becomes less attractive to hoard money than invest and spend while its cheap. The Fed is well places to hike rates with inflationary forces supported by a pick up in money stock.png

  • More reserves are needed to lead to growth in deposits because commercial banks must issue additional liabilities or equity to “fund” any increases in their asset holdings due to higher reserves.
  • Low interest rates, especially a zero interest rate, make noninterest balances relatively more attractive by reducing the interest rate penalty associated with holding money balances. This effect is consistent with a traditional money demand equation.
  • More lending by banks, much like higher reserves held by banks, requires banks to attract deposits or other liabilities to fund the loans.

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