Tuesday, December 12, 2017

Broad Tightening Ahead, and The Phillips Curve Problem

Is it a lack of faith in high labour force participation levels for the near future, which encourages central bankers to continue tightening monetary policy? Or - instead - are central bankers inclined to believe that employment for all who seek it, is strong and will remain so? Something about actual employment and cumulative output gains, isn't quite adding up. According to Bloomberg:
Wall Street economists are telling investors to brace for the biggest tightening of monetary policy in more than a decade.
And it isn't just Wall Street, because other central bankers will be following the lead of the U.S. in this regard. Much of the rationale for doing so, has been based on the Phillips curve as an indicator of an "overheating" economy. But what, exactly, is overheating? Plus: Given an undue emphasis on the Phillips curve - even though its reliability is dubious for mature economies with services dominance - central bankers are likely to continue tightening monetary conditions in the near future. They appear determined to do so, even though dependence on the Phillips curve relationship between employment and inflation, has become problematic.

What makes the Phillips curve an ill suited economic indicator? Among the possible reasons, is a strong institutional trend away from price taking toward price making, in recent decades. Price making occurs at so many levels of product formation, that it negatively impacts overall productivity and investment. In particular, the employment losses which accrue from price making, aren't just a problem for societal coordination. They also make it difficult, to correlate today's supposed "full" employment levels with inflation expectations.

When tradable sector activity was still dominant, so too was price taking, as a coordination factor among many firms. The once natural tendencies of price taking, also meant firms had more options for hiring, based on the optimal resource capacity at their disposal. But as non tradable sector activity came to the fore, its organizational capacity contained numerous incentives for price making, which meant a certain degree of employment potential would be left on the sidelines.

This lost employment potential is doubtless a factor, in the gradual (long term) decline of labour force participation. Unfortunately, the Fed is paying closer attention to recent employment statistics for decision making, instead of what has occurred to aggregate employment levels over time. Indeed, gradual employment losses are reminiscent of the nominal level target losses which were incurred in the onset of the Great Recession, even though those losses took place within a single time frame.

Some are well aware of what the Fed has not considered, regarding aggregate employment circumstance and the nominal income losses of the Great Recession which were never fully regained. Even though market growth presently appears strong, investors are not quite as bullish as economists, this time around. And perhaps for good reason.

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