In 1977, Congress reformed the 1913 Federal Reserve Act, tasking the Federal Reserve with three main objectives: maximize employment, maintain stable prices, and moderate long-term interest rates. Often, these three objectives are boiled down to what is known as the Fed’s “dual mandate” to reach full employment and maintain price stability.
In mainstream economics, the price level and employment rate are often linked by the Phillips curve (pictured above), an economic model that states there is an inverse relationship between the unemployment rate and inflation. Put simply, as unemployment falls, prices rise. As more people are hired and wages rise due to competitive pressures within the labor market, aggregate demand increases and pushes the price level up.
The Phillips curve has guided economic policy in the United States for decades. In fact, Gregory Mankiw, a professor of macroeconomics at Harvard, cited the trade-off between inflation and unemployment as one of the “Ten Principles” of economics in the first chapter of his immensely popular textbook, Principles of Economics. Mankiw served as Chairman of the Council of Economic Advisers under George W. Bush from 2003-2005 and also served as an economic adviser to Mitt Romney’s campaigns in 2008 and 2012. Originally released in 1997, Principles of Economics has sold more than one million copies, generating an estimated $42 million in royalties for Mankiw.
Despite the prevalence of the Phillips curve in mainstream economic thought, the data tells a different story:
The US is in the midst of its longest economic expansion in history, beginning in June of 2009 and continuing through today. The unemployment rate has shrunk from a high of 10% in 2009 to only 3.7% — yet inflation has remained subdued as unemployment has decreased. This, of course, directly contradicts what Mankiw and the Phillips curve tell us about the economy.
This is also not the first time the concept of the Phillips curve has been questioned. Milton Friedman originally proposed the concept of a “natural rate” of unemployment in the late 1960s. In the 1970s, the United States experienced what’s known as stagflation — high unemployment along with high inflation. Economists searched for alternative explanations. Elaborating on Friedman’s “natural rate” concept, Franco Modigliani and Lucas Papademos introduced the “non-accelerating inflation rate of unemployment” or “NAIRU” in 1975.
In contrast to the Phillips curve, the gist of the “natural rate” or “NAIRU” theory is that if unemployment drops below a certain “natural” level, say 5%, inflation will occur, inflation will accelerate, and very bad things will happen. The Fed operates under this thinking today. Here’s a quote from Fed Chairman Jerome Powell in January of 2019:
In other words, the Fed’s NAIRU estimate (at least in part) determines policy choices when it considers its dual mandate of maximizing employment while maintaining price stability. If unemployment starts getting too low, the Fed will attempt to slow the economy down so wages do not increase and set off inflation. Let’s take a look at the Fed’s NAIRU estimates:
As we can see, the NAIRU estimate has ticked lower and lower since 1980. We’ve seen both the NAIRU estimate and unemployment rate drop substantially yet no significant corresponding inflation. Perhaps it’s time for the Fed (and the Congressional Budget Office) to revise its models when it comes to maximizing employment.
Love her or hate her, this was the heart of what Alexandria Ocasio-Cortez was driving at while questioning Jerome Powell last week:
Why is all of this important? Real wages in the United States have been stagnant for decades:
Despite the stock market continuing to hit all-time highs, workers aren’t seeing wage growth. In Powell’s words:
Powell conceded that workers have lost out on their share of national income, saying “Go back to the turn of the century: What you saw was a decline in the labor share, and that has not been reversed…” A first step toward remedying that problem could be jettisoning the notion of the unemployment/inflation trade-off from the Fed’s modeling and policy interventions.