Wednesday, July 11, 2007

Fond Farewell to the Phillips Curve?

"Still, I think we can agree that, at a minimum, the opposite proposition--that inflationary policies promote employment growth in the long run--has been entirely discredited and, indeed, that policies based on this proposition have led to very bad outcomes whenever they have been applied."
– Fed Chairman Ben Bernanke speaking before the National Bureau of Economic Research yesterday.

If Ben Bernanke is dissing the fossilized Phillips curve as a monetary indicator and as an inflation forecaster (as seems to be the case based on his remarks), well, that would be a very good thing indeed. More Americans heading off to work and prospering simply does not cause inflation.

Excess money created by the Fed causes inflation.

And, as I’ve argued on countless occasions, it does not appear that we are faced with an excess money situation. Commodity markets continue their boom principally because of vigorous global economic growth, not inflation.

In addition, U.S. bond market spreads -- particularly the difference between market Treasury bond rates and inflation-adjusted Treasury bond rates -- suggest that inflation is moving sideways at just around 2 percent. The actual inflation data from the consumer spending deflator corroborates this view. Importantly, the Fed has contained monetary base growth for years. This may be why rising energy prices have not leaked through to the core inflation rate.

As a result, I still don’t look for any change in Fed policy in the foreseeable future. The not-too-hot, not-too-cold Goldilocks economy and the stock market are doing just fine without any Fed fine-tuning.

Incidentally, Mr. Bernanke mentioned the TIPS inflation spread several times during his speech yesterday. This appears to be a key indicator for him. Good.