Bye-Bye Phillips Curve?

The Fed is apparently abandoning its unemployment target -- aka the Phillips Curve -- according to this morning’s front page Wall Street Journal article. On the surface this is a good idea, because inflation is caused by printing too much money, not by more people working and prospering.

Keynesian central planners have always liked the Phillips Curve because it gives them an excuse to fine tune the economy, as though they know better than markets. But as Milton Friedman taught us, inflation is a monetary phenomenon. However, it’s not clear what is replacing the unemployment rate target.

The article suggests that inflation is caused by higher rents and oil prices. This is nonsense. Prices don’t rise because other prices are rising. The general level of all prices goes up when excess money creation devalues the exchange rate of money.

Are we to conclude that the Fed is now targeting money either through commodity indicators like gold; or bond market indicators like the TIPS inflation spread; or even the money supply itself, especially the monetary base? The article doesn’t answer these important questions.

Right now signals are mixed. For example, gold prices have been rising, which is traditionally an inflation warning sign. However, bond rates are low, the yield curve is inverted, and the TIP inflation spread remains low. This suggests no inflationary problem.

Ultimately, if the value of money declines significantly, then price indexes will rise substantially. Right now there are mixed signals.

In another area, home prices are falling -- a potential deflation sign. So, there’s even more ambiguity.

On these topics, this morning’s WSJ story raises more questions without offering any particular answers. Targeting any form of economic growth or the unemployment rate is a lousy idea. But what will replace it?

Finally, House Financial Services Committee Chair Barney Frank believes the Fed is over-obsessing about inflation and opposes a strict inflation target. He wants the central bank to keep a sharp eye on the unemployment rate. So the Fed story may cause some political friction, as well as some analytical confusion.

Core inflation is now running at a 2.2 percent rate according to the Fed’s favorite measure of the personal spending deflator. This is just above the bank’s 2 percent target. Perhaps, at the end of the day, the Fed is moving towards a straight out inflation target. This could qualify as a price rule even though it avoids leading indicators like gold or bond rates.

We’ll have to wait and see if there’s any clarification from Bernanke & Company.