The Fed relies on a model that only works when its policy fails
By Scott Sumner
I’ve made this point before, but it’s worth repeating, given all the recent talk about the Fed relying on the Phillips Curve. The Phillips Curve model only works when the business cycle is driven by demand shocks. When we are hit by supply shocks the Phillips Curve actually slopes upward; inflation is higher during recessions.
It’s the Fed’s job to prevent demand shocks, which means it’s the Fed’s job to make the Phillips Curve model false. So why are they relying on that model to predict an upswing in inflation as unemployment falls below 5%?
Here’s an easier way to think about it. Imagine a single mandate, where the Fed keeps inflation right at 2%, all of the time. In that case the Phillips Curve is horizontal; there is zero correlation between inflation and unemployment. Now assume Congress adds a second mandate—employment. The Fed would do a bit more expansionary policy when unemployment was high, and vice versa. They would still keep inflation stable at 2%, on average, but allow some year to year fluctuation in inflation to smooth out unemployment. A bit more than 2% inflation when unemployment is high, and a bit less than 2% inflation when unemployment is low. In that case inflation will be countercyclical, exactly the opposite of the prediction of the Phillips Curve model.
So why is the Fed using the Phillips Curve to forecast inflation?
And why is it that when I mention this simple point, right out of EC101, so many economists give me a “funny look”?
PS. I do understand that the Fed can’t entirely prevent demand shocks, and hence occasional periods of procyclical inflation. But surely they should set policy in such a way that they forecast an outcome that is consistent with their policy goals.