Winning a Computer Game, But Losing In Real Life

On today’s show we are talking about inflation and whether higher interest rates will even help.

When you listen to Fed chairman Powell speak, he spends a lot of time talking about inflation expectations. In fact, he mentions inflation expectations as being anchored in virtually every speech.

So what is this anchoring of expectations and does it even matter?

There was a paper published in May of this year by two economists who work for the Fed. Jae Sim and David Ratner wrote a paper entitled, “Who Killed the Phillips Curve? A Murder Mystery”. In order to understand the paper we first need to describe the Phillips curve.

The Phillips curve has longstanding model of inflation and employment, and perhaps the central model underpinning the Fed’s monetary policy. The experience in the last decade puts in doubt the stability and usefulness of the Phillips curve in predicting inflation and conducting monetary policy. First, the Phillips curve failed to predict the stable inflation seen in the aftermath of the Global Financial Crisis.

In my opinion, there could be several explanations for this.

1. There is real inflation happening underneath the covers which is not being captured in the CPI metrics. That’s one possibility.
2. The model for predicting the way inflation and the economy works is fundamentally flawed and doesn’t track the real behaviour of the economy.

A growing number of economists and commentators of different backgrounds have gone so far as to declare the death of the Phillips curve.