50 Years And Phillips Curve Insanity

“Insanity is doing the same thing over and over again and expecting different results.”

(Usually attributed to Albert Einstein, this familiar quote may have originated with Max Nordau or others in history. Here’s the citation from Quote Investigator for those who like words and researching their origins and usage. We’ve drawn no conclusions about who said it.)

Let’s get to 50 years of insanity and counting!

Here’s the SEP (Summary of Economic Projections) released in December by the Federal Reserve.

For release at 2:00 p.m., EST, December 14, 2022. Summary of Economic Projections.In conjunction with the Federal Open Market Committee (FOMC) meeting held on December 13-14, 2022, meeting participants submitted their projections of the most likely outcomes for real gross domestic product (GDP) growth, the unemployment rate, and inflation for each year from 2022 to 2025 and over the longer run. Each participant’s projections were based on information available at the time of the meeting, together with her or his assessment of appropriate monetary policy – including a path for the Federal funds rate and its longer-run value – and assumptions about other factors likely to affect economic outcomes. The longer-run projections represent each participant’s assessment of the value to which each variable would be expected to converge, over time, under appropriate monetary policy and in the absence of further shocks to the economy. “Appropriate monetary policy” is defined as the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the statutory mandate to promote maximum employment and price stability.

Readers, please note that two of the metrics used by the FOMC are the inflation rate as determined by the personal consumption expenditure deflator (PCE) and the unemployment rate (UR). The third metric used regularly in the SEP is an estimate of the growth in GDP, and a fourth metric is the core PCE. Also note that the GDP estimates are revised several times before they are thought to accurately reflect the growth rate of the US economy.

We will stick with PCE and UR for today’s commentary.

Here’s a history lesson about the PCE and the UR during the entirety of Cumberland’s existence and with the respective Fed chairs listed and color coded so readers may follow their tenures.

I have examined the trajectory of the Phillips curve, which maps the relationship between these two measures during the entire 50 years of Cumberland’s history and preceding Cumberland’s founding in 1973. It has demonstrated no reliability in forecasting the future. The only thing apparent is that the slope of the Phillips curve is constantly changing. An abundance of research has confirmed my observation.

If the Phillips curve is not a measure that enables reliable forecasting, why does the central bank continue this insanity? Either expand the list of items, and maybe, attach the names of FOMC members to their forecasts and let them explain their positions to the public, or else admit that the Phillips curve is a deficient metric and deal with other metrics instead when using the SEP.

The aphorism “It is dangerous to make forecasts, especially about the future” (which did not originate with Yogi Berra, Samuel Goldwyn, or Niels Bohr, despite the human predilection for attributing pithy sayings of obscure origin to anyone famous) applies.

So, if the Phillips curve is unhelpful and if forecasting with it in a traditional way is flawed, what do we do? Old habits are hard to change.

At Cumberland, we try to understand why things are influenced in ways that were not apparent in the past. Here’s what we see in the labor force that is presently guiding us. We thank Torsten Slok of Apollo Academy for permission to use his chart from the February 4 edition of The Daily Spark, “Starting to Look Like a ‘No Landing’ Scenario”:

Clearly, using the unemployment rate when there are so many more job openings than jobseekers is a flawed approach. Also, until the Covid shock, this condition had not been present in the half-century of Cumberland’s history. Perhaps the FOMC can add the members’ estimates for additional dots to the dot plot and ask each of them to insert their estimate for the JOLTS data and for the underemployment rate, meaning those who work part-time because full-time work is not available. While they are at it, the FOMC members could also add their estimate of the future labor force participation rate.

Our view remains the same: The Fed will remain tight and in tightening mode until (1) there is a huge financial accident or crisis such that they must pivot to save the banking system or financial system because of the shock, or (2) the jobseeker-versus-job openings metric depicted in Torsten Slok’s chart is restored to the historical relationship. Until one of these two things happens, the Fed’s policy will stay on a trajectory of tightening.

Our US Equity ETF portfolio continues to hold a cash reserve. We are not sanguine about the outlook, and I want to thank Rishaad Salamat of Bloomberg TV and Radio for inserting the word sanguine in our recent interview with him, which can be found here.

I believe that the Federal Reserve is determined to return the inflation rate to the 2% PCE target for the medium term. I expect that, for them to reach that goal, wage pressures have to be alleviated. I do not expect the current Congress to open the immigration channel to allow more workers into the US. That source of labor is now 2 million workers behind its pre-Covid baseline, in our opinion. Our nation cannot replace the 1.2 million Covid dead (about 500,000 were working at the time of their death), nor are we seriously addressing the long Covid-disabled. Congress is reluctant to fund the medical research needed to solve this problem afflicting about 8% of the US population, many of whom are in the labor force age range. (There are various estimates, ranging from 6% to 11% of the population, with a form of long Covid disability; I use 8% for economic-projection purposes, and I use 3 million as the estimate of labor force shortage due to long Covid.)

So, my 50 years’ experience at Cumberland and those few working years that preceded Cumberland’s founding are telling me that “this ain’t over” and that any forecasting done today has a huge margin for error.

For those readers interested in a historical view, here’s the Wikipedia summary of the Phillips curve and references to how it is flawed. (For the source notes, please access the article at the link above.)

The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship between employment and inflation, this was a trivial deduction from his statistical findings. Paul Samuelson and Robert Solow made the connection explicit, and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place.While there is a short-run tradeoff between unemployment and inflation, it has not been observed in the long run. In 1967 and 1968, Friedman and Phelps asserted that the Phillips curve was only applicable in the short run and that, in the long run, inflationary policies would not decrease unemployment. Friedman then correctly predicted that in the 1973–75 recession, both inflation and unemployment would increase. In the 2010s, the slope of the Phillips curve appears to have declined and there has been controversy over the usefulness of the Phillips curve in predicting inflation. A 2022 study found that the slope of the Phillips curve is small and was small even during the early 1980s. Nonetheless, the Phillips curve remains the primary framework for understanding and forecasting inflation used in central banks.

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