There’s quite a bit to comment on in David Malpass’s new op-ed in the Wall Street Journal. If his name doesn’t ring any bells Mr. Malpass is an economic analyst and former government official in the first Trump Administration. The op-ed is ostensibly a call for the Federal Reserve to update its “economic models” but I think there’s more going on in it.
The Federal Reserve’s outdated economic models and board structure are pushing it toward interest-rate increases that would hurt affordability and small businesses without curbing inflation. This approach risks keeping bond yields and mortgage rates higher than necessary while waiting too long to cut rates. Instead, the Fed should consider broadening its models to include the value of the dollar as a key factor in price stability, which would help deliver low inflation, fast growth and dollar dominance.
Perhaps his sharpest criticism is levelled at the Phillips Curve, the empirical observation that inflation and unemployment are inversely correlated:
Better data and analytical tools will help, but the Fed faces larger problems. Its old-fashioned models exclude the dollar even though its value significantly affects inflation and price stability. The models also assume that faster growth and wage gains cause inflation and that higher rates are the best tool to slow it.
It is hard to see how. Even with better data, inflation is a flawed guide to setting rates. It depends on factors beyond the Fed’s control, such as gasoline and diesel prices, and on liquidity in the economy from asset-price gains. Inflation also depends on the dollar and external supply factors such as energy production, deregulation, wage growth, tariffs, innovation, tax cuts and China’s pricing decisions.
When I took economics courses, the better part of a century ago, the Phillips Curve was taught as Holy Writ. When Congress defined the Fed’s “dual mandate” in the late 1970s, the Phillips Curve was still influential in economic thinking about the relationship between inflation and unemployment. Keeping prices stable while minimizing unemployment. Is the Phillips Curve actually obsolete? Or has the Federal Open Market Committee (FOMC) managed to thread that needle for the last 35 years? I don’t know and Mr. Malpass presents no evidence to suggest otherwise.
A fact I think that Mr. Malpass should take into consideration is that Paul Volcker’s success in curtailing inflation with high interest rates 45 years ago is the baseline, the standard of comparison. His actions were necessary due to the previous 20 years’ worth of bad fiscal and monetary policy, including excessive federal spending, accommodative monetary policy, and the disastrous experiment with wage and price controls, compounded by external shocks. Bad fiscal policy is the underlying cause of the present riots in France.
Here’s the kernel of his op-ed:
Bond markets are pricing in painfully high interest rates for the foreseeable future because of the Fed’s models. Hence the rise in bond yields and mortgage rates contributing to losses in the equity markets. Higher-than-necessary rates will also add significantly to the U.S. budget deficit given the size and short maturity of the national debt.
Is that true? The market is charging for risk, including fiscal risk and the consequences of Treasury supply, as well as forecasting the Fed’s rate path. Here’s the St. Louis Federal Reserve’s chart of 10-year Treasury rates over the last 60 years:
You may draw many conclusions from that but a conclusion you cannot reasonably draw is that bond rates are presently “painfully high”. They’re well below the extraordinary levels of the early 1980s but whether they’re excessively high today depends on inflation expectations, real interest rates, and the risks investors perceive. Mr. Malpass provides no evidence that the Fed’s models are responsible for those risks.
Here’s his conclusion:
A final point: Including prices and viewing growth as a positive factor in the Fed’s models would increase investor confidence in the dollar’s value and attractive returns on Treasurys. Linking the Fed’s price-stability mandate to a stable dollar would also solidify the dollar’s market share in the rapid growth of digital currencies and stablecoins. Dollar stability would, in turn, intensify pressure on China’s investment portfolio, which is underweight the dollar and overweight zero-yielding gold.
Would faster interest rate changes be an improvement over the status quo? I won’t argue that the Fed shouldn’t update its models. The question is to what end. I would argue that the Fed should keep its present mandate (stable prices and low unemployment) and eschew the “Greenspan put” (ensuring that asset prices rise). IMO what we face right now just as 45 years ago is the consequence of bad fiscal policy. That’s outside the scope of the Fed. The responsibility for that is with the Congress and, as we have seen, the executive.
Is Mr. Malpass really arguing for better economic models or is he arguing for models that will justify the policies he already favors?
Forget the whole political discussion and focus on the economic impact of interest rates and how they impact inflation. The political side pushes people into their tribes. The basis behind the Philips curve is that interest rates affect employment which in turn impacts prices through higher wages. One thing that has changed in the last 50 years is that the percentage of GDP that is wages has declined by a decent margin so the wage impact on inflation should be smaller.
https://fred.stlouisfed.org/graph/?g=ans
On the employment side in terms of first time unemployment claims, the first time claims as a percent of the workforce is at a record low. Back in the 1980’s, inflation was higher than today, yet unemployment was also higher. I remember the rule of thumb in the 1980’s was a recession is happening if first time claims were over 400,000/wk. Full employment would have claims below 300,000/wk. Today, first time claims are under 200,000/wk and the civilian labor force has increased from 110 million to 170 million since the 1980’s. The Phillip’s curve does not explain this. Capital spending and investment allows this. Lower interest rates will help make capital available to improve efficiency.
Another shortcoming is the impact of interest rates on housing. Lower interest rates will reduce the out of pocket housing cost for people with a mortgage. This can also happen indirectly where a landlord must raise rents to cover a higher interest mortgage. I think housing accounts for about 1/3 of the inflation calculation.
The flip side of this is around asset prices. The lower interest rates tend to drive up asset prices which bleeds into other areas. The sales price of a home may increase with lower interest rates. As stock prices increase, people feel the wealth effect and drive up prices for other items (like more expensive homes). This is a similar response as the Phillip’s curve, but the mechanism is different.
I will strongly agree that fiscal policy plays a huge role in inflation. We can have high inflation and high unemployment at the same time. The 1970’s showed this – so did Zimbabwe and Venezuela. I want us to fix the government side. This includes government spending, regulations, perverse incentive, etc.