MNI FED INSIGHT: Hawks Winning Phillips Curve Debate, For Now

By Karen Mracek

     WASHINGTON (MNI) - While the Phillips curve is extremely flat, it is not

yet dead -- at least not in the eyes of the majority of U.S. monetary

policymakers, MNI understands.

     Those hawkish members of the policymaking Federal Open Market Committee are

winning the argument that tighter labor market conditions will lead to higher

inflation, thus supporting the FOMC's pressing ahead on rate normalization.

     This belief that the Phillips curve will someday reassert itself as labor

conditions continue to tighten means the FOMC is more likely to stick to the

projections in its Summary of Economic Projections, which call for another hike

this year and three in 2018, than to be thwarted by a few weak inflation

readings.

     Lack of inflation growth has been perplexing policymakers for several years

now, and low readings earlier this year caused some FOMC members to sound more

dovish about the rate outlook, backing off the idea of more rate hikes.

     But while there have been some high profile reports of the death of the

Phillips Curve, the majority of FOMC members aren't convinced. Hawkish members

who still believe in the Phillips Curve make up the majority in part because

there is no good alternative explanation for why inflation is so low.

     Still, a belief in the Phillips curve does not necessarily mean the FOMC

will plow ahead with rate hikes if they are worried about low inflation. As some

have said, the lower inflation gives them room to be patient. It's just that the

hawks expect the Phillips Curve to reassert itself as the FOMC keeps rates low

and the unemployment rate continues to undershoot longer run expected levels.

     Among the Phillips curve believers, there are still two camps -- those who

see risks growing now from the undershoot on unemployment and those who are

still willing to be patient on rate hikes. 

     Belief in the Phillips curve does not necessarily mean the hawks are

aggressively pursuing rate hikes, just that they support continued normalization

of the policy rate to mitigate risks that would necessitate a faster than

expected rise in the fed funds rate.

     The FOMC at its July meeting debated this framework, in which "for a given

rate of expected inflation, the degree of upward pressures on prices and wages

rose as aggregate demand for goods and services and employment of resources

increased above long-run sustainable levels."

     A few participants said this framework "was not particularly useful in

forecasting inflation," the minutes said. "However, most participants thought

that the framework remained valid, notwithstanding the recent absence of a

pickup in inflation in the face of a tightening labor market and real GDP growth

in excess of their estimates of its potential rate."

     The majority of FOMC members still believe a tighter labor market will lead

to higher inflation and this will necessitate higher rates. 

     As of June, the median fed funds rate expected by FOMC members at the end

of 2017 was 1.4% which implies one more rate hike this year, with a median core

PCE reading expected at 1.7%. More importantly though, the median core PCE

inflation was marked down for 2017, but FOMC members still expect it to reach 2%

in 2018. And with that progress, they expect three rate hikes will be

appropriate next year.

     These projections will be updated at the September meeting, but a

significant downward revision to core PCE inflation for next year is not likely.

The debate will continue as long as inflation comes up weaker than expected, but

so far policymakers are not ready to give up on this time-tested theory.

--MNI Washington Bureau;tel: +1 202 371-2121; email: karen.mracek@marketnews.com

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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