A Phillips-curve Fed?

Back on March 4, we pointed out a troubling quotation by Fed Chairman Ben Bernanke, in which he indicated his opinion that slowing economic growth could lower inflation and moderate energy prices.

In light of the market turbulence in the wake of this week's Fed decision, that post from March 4 is worth a second review. In it, we stated that a belief by the Fed that slowing growth or, more specifically, rising unemployment will dampen inflation -- a connection called the "Phillips curve," shown in the drawing above from 1950s economist A. W. Phillips -- threatens to destabilize the dollar. We pointed out that the Phillips curve has been resoundingly proven wrong in the fifty years since its introduction, and that it was economists such as Milton Friedman who rebuked that theory and helped lead the way out of the stagflation of the 1970s. Mr. Friedman also taught us that inflation is a monetary phenomenon caused by too much money chasing too few goods. The Fed is being loose with money creation now (too much money) and that is creating the rise in prices for commodities like food and oil (not enough available).

Recently, Steve Forbes lamented the damaging effects of "the excess liquidity the Federal Reserve has created since 2004" in this opinion published on June 16. In particular, he argues that the Fed's most recent loosening from 5.25% to 2.00% on the target Fed Funds rate is directly responsible for oil's rise from $70 a barrel in August to today's record prices, which is a point we also made in this post from June 4. Tellingly, Mr. Forbes asserted in that article his belief that "the Federal Reserve is still in thrall to the Phillips curve."

The editorial staff of the Wall Street Journal today analyzed yesterday's dramatic market sell-off and blamed it on concerns that the Fed will continue to let inflationary pressures rage and the dollar collapse, pointing for evidence to the fact that gold and oil both shot up sharply yesterday (see here for their article).

The Federal Reserve's statement from Wednesday said "The Committee expects inflation to moderate later this year and next year." Exactly how do they expect inflation to moderate? Do they believe it will moderate all by itself, based on the fact that, as they noted, "labor markets have softened further"? Does this confirm that the Fed is indeed still in thrall to the Phillips curve?

Economist Brian Wesbury noted that the Fed's statement is much more hawkish than their April statement, raising hope that the Fed is keenly aware of the inflation danger and that they stand ready to correct the monetary situation and begin moving to stabilize the currency.

We agree that the Fed must tighten rates in order to stop the problem, which will not go away by itself, and the sooner the better. We hope that a mistaken belief in the Phillips curve doesn't cause them to wait for inflation to moderate on its own. That could well be a long wait!

For later blog posts dealing with this same topic, see also:

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