The Phillips Curve and the Fed’s wage insurance policy

Treasury rates peaked and began falling five weeks before the Federal Reserve’s final rate hike on December 19^th last year to 2.5%.  By the evening before that FOMC meeting the 10-year Treasury had already lost 42 basis points from 3.24% on November 8^th to 2.82%. The 2-year had shed 32 points, 2.97% to 2.65%.

Rates have once again turned.  The 10-year has gained 18 point to a 2.13% close on July 11^th. The 2-year has added 13 points to 1.86% also on the 11^th. It traded as high as 1.92% on the 9^th.

Reuters

It is far too early to tell if this is a reaction and profit taking on the eight month rise in bond prices or a hint that the odds of three or more cuts in the immediate future are waning in view of the June success at job creation. The sharp run higher in yields began on July 5^th after the NFP report.  

The Fed’s economic concerns from the beginning of the rate pause in January have been the US-China trade deal, Brexit and the slippage in global growth. Those remain today though Brexit seems to have wandered from immediate consideration.  To them Chairman Powell has added the lack of sufficient wage gains to drive inflation. 

Mr.  Powell’s focus on wages and prices is less about inflation directly, though the Fed pays frequent homage to its Congressional price stability mandate, than to the wage component. 

The Chairman noted several times in his two days of testimony that the long running expansion, recently a post-war record, had finally begun to deliver substantial wage gains to middle and lower class workers and that the very low level of unemployment had brought jobs to communities long outside of the general workforce. He stressed that keeping the economy in growth was one of the governors’ main considerations.

In response to a question in the House from Alexandria Ocasio-Cortez, the freshman Congresswoman from New York suggesting that the Phillips Curve, describing the relationship between unemployment, wages and inflation had largely broken down, he agreed.

That equation between the unemployment rate, wages and inflation holds that as the unemployment rate drops employers are forced to offer workers higher wages fueling inflation.

When the Philips Curve was first formulated in 1958, the global market was far more limited than it is now. The impact of trade on wages was minimal. National workers were not, by and large, competing with foreigners and so the domestic unemployment rate related to the wages employers had to pay to secure employees. 

That is barely true now. The relationship has weakened as more and more production is or can be sourced overseas in cheaper wage environments. The Detroit auto worker or Pennsylvania steel hand is competing directly with workers in China and India and Vietnam. The labor market is global and it has effectively killed the national Phillips Curve. It has not yet been replaced, as it theoretically could be, by a global Phillips curve in a seamless world labor market.

Which brings us back to a Fed that is ready to cut rates on what would normally be considered tenuous economic grounds.

The economy is growing moderately, 2.25% in the first half if the Atlanta Fed GDPNow 1.4% second quarter projection is accurate.  The bank’s final first quarter estimate of 2.7% was slightly under the final BLS measurement of 3.1%. Inflation is between 2.1%, core CPI and 1.5%, PCE price index, the labor market is healthy and wages are rising. Jobless claims and the unemployment rate are at levels that the 65% of the population under 50 have never witnessed.

If the expansion grinds to a halt or slips into a recession even if it is not a serious or prolonged downturn all the slowly accumulated pressures on wages would be lost.  As wage increases are strongest in the last stages of an expansion it might take several years into the next recovery for unemployment to drop far enough to produce salary benefits, or it might never happen.

Wages did not start to open an appreciable gap over inflation until the second half of 2016. That edge which translates into disposable income continued to improve to its widest in a decade when, in August 2018 annual wages gains vaulted over 3%, where they have remained.  The last eleven months have seen the best sustained wage increases since the recession.

Reuters

It is these wages accruing to all groups in society, but particularly to the most marginal and previously unemployed workers that Chairman Powell and the Fed governors are striving to retain and enhance.

Given the barely discernable impact of monetary policy, quantitative easing and seven years of zero rates on US prices, the demise of the Phillips Curve is just additional collateral when the Fed takes out its wage insurance policy on the 31^st.