"The Fed cannot be complacent about inflationary pressures"

“The Fed cannot be complacent about inflationary pressures,” is the message that Peter Hooper, Deutsche Bank’s Global Head of Economic Research, highlights in a new paper he co-authored, entitled “Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or is It Just Hibernating?” Presented at the 2019 US Monetary Policy Forum, the paper addresses the Phillips curve in the US, which predicts that when unemployment drops inflation will rise due to competition for labour and higher wages.

The authors note that monetary policy and market behaviour have been increasingly influenced by the view that the Phillips curve has flattened, and therefore inflation is unlikely to be boosted by further tightening of the labour market. One of the key elements in the research was a careful look at what happened during the 1960s, which was the last time that low unemployment and rising wages sparked inflation.

“There is a risk that inflation could swiftly break out of its recent doldrums especially if political pressures begin to influence market expectations, which is what happened in the 1960s,” the authors noted.

Together with his Rick Mishkin (Professor of Banking and Financial Institutions, Columbia University and Research Associate, National Bureau of Economic Research) and Amir Sufi (Professor of Economics and Public Policy, University of Chicago and Research Associate, National Bureau of Economic Research), Hooper concludes that the Fed needs to be especially watchful about inflation if the labour market continues to tighten – something that Deutsche Bank’s US economists are projecting.

Future plans

Mary Daly and John Williams, presidents of the San Francisco and New York Federal Reserve Banks respectively, praised the study for its comprehensive approach and findings. They stated, however, they would be more balanced in their warnings against Fed complacency. For example, they would charge the Fed to be wary of inflation falling too low as well as moving too high. They noted that inflation is still running a bit below target and some measures of inflation expectations have been slipping of late.

Fed Vice Chair Rich Clarida observed that the paper’s interesting finding of a flattening in the price Phillips curve but not the wage Phillips curve may well reflect a trend decline in labour’s share of total income, a trend that would have depressed the slope of the Phillips curve. This is an avenue of research that Hooper and the team of US economists plan to pursue further.

Most of the quantitative work for the paper was done at Deutsche Bank, with input from Justin Weidner, US Economist, assisted by Suvir Ranjan, Research Associate. It also drew on related research by Matthew Luzzetti, Chief US Economist.