Good news on the economy remains bad news for Wall Street, and stocks are falling Friday on worries a still-strong U.S jobs market may actually make a recession more likely.
The S&P 500 was 2.1% lower in midday trading after the government said employers hired more workers last month than economists expected. Wall Street is worried the Federal Reserve could see that as proof the economy hasn’t slowed enough yet to get inflation under control. That could clear the way for the Fed to continue hiking interest rates aggressively, something that risks causing a recession if done too severely.
“The employment situation is still good and that might be a little frustrating to the Fed,” said Brian Jacobsen, senior investment strategist at Allspring Global Investments. “The Fed thinks we need more people unemployed in order to make sure inflation comes down and stays down.”
If you think this sounds a little crazy – that a good jobs report was actually bad news because it meant that not enough people were unemployed to get inflation down so the Fed will need to raise interest rates higher which might cause recession – I don’t blame you. It mistakes a probable side effect – unemployment – for the actual cure – a slower rate of money growth.
One of the most striking things to come out of Nick Timiraos’ new book ‘Trillion Dollar Triage: How Jay Powell and the Fed battled a president and a pandemic – and prevented economic disaster’ is how wedded the Federal Reserve still is to the Phillips’ Curve. This is the belief that the inflation rate and the unemployment rate move in opposite directions. It gives policymakers the tools to manipulate either, so unemployment can be pushed down by raising inflation and inflation can be lowered with higher unemployment.
The trouble is that the Phillips’ Curve simply doesn’t exist. It is a fact of certain data from a certain period of time. As I’ve written before:
It was named after the economist A.W. Phillips who, in 1958, found a correlation in a century’s worth of British data between unemployment and the ‘rate of change of money wage rates’. In 1960, economists Paul Samuelson and Robert Solow elevated this into a tool for macroeconomic management. Policymakers could buy lower unemployment at the price of higher inflation and they could buy lower inflation at the price of higher unemployment.
In 1968, the economist Milton Friedman dismissed the idea that this historical fact was some immutable law:
The essence of the Phillips Curve lay in using increases in a nominal variable – prices – to fool producers into increasing real variables, such as output and employment. But, Friedman argued, at some point economic agents would wise up to this. They would start to take expected inflation into account, by such methods as indexing contracts. Monetary policy would lose its traction on employment and, indeed, inflation and unemployment could rise together.
Despite much initial skepticism from his peers, Freidman quickly came to seem clairvoyant. Through the 1970s, the Phillips Curve started shifting around. In 1971, Arthur Burns, Chairman of the Federal Reserve, complained that “The rules of economics are not working in quite the way they used to. Despite extensive unemployment in our country, wage rate increases have not moderated. Despite much idle industrial capacity, commodity prices continue to rise rapidly.” The relationship between inflation and unemployment ceased to be a useful policy variable.
This resulted in a complete rethinking of monetary policy. Instead of using monetary policy to stabilize real variables like employment or output, it would be used to stabilize monetary variables, such as inflation. Inflation targeting became the chief goal of monetary policymakers worldwide.
And yet, as Timiraos explains, this none-existent curve is driving monetary policy. The Fed is trying to aim for a ‘cooler’ job market as a way of ‘cooling’ inflation when, as we’ve known since the 1970s, the one doesn’t drive the other. This really is zombie economics.
There is good news here. As Figure 1 shows, rates of growth for the Monetary Base and the broader measure of money, M2, which is tied more closely to price inflation, have declined and, in recent months, turned negative. This should mean that inflation will soon fall.
By using the Fed funds rate to conduct monetary policy, the Powell Fed is trying to use the price to solve a quantity problem. It can do this, but only inexactly. The Volcker Fed, which tamed high inflation the last time, tackled the quantity problem by getting to grips with the quantity directly.
Making credit scarcer, which is the result of restraining money growth, will, ceteris paribus, tend to make credit more expensive and this will push interest rates up. This happened under Volcker. As I wrote recently, as he tightened money growth:
…rates on three-month Treasury bills exceeded 17%; the commercial bank prime-lending rate hit 21.5%; mortgage rates approached 18%.
The consequences were brutal. Real GDP fell at an annual rate of 2.1% in the second quarter of 1980 and the unemployment rate rose from 5.6% in May 1979 to a peak of 10.8% in November and December 1982.
So we can probably expect some higher unemployment, but as a side effect of the cure for inflation: it is not the cure itself.