QE3 ON ITS WAY AS FED PREPARES PHILLIPS TRIAL / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

Markets Insight

November 1, 2011 3:34 pm

QE3 on its way as Fed prepares Phillips trial

By Scott Minerd

When Ben Bernanke, chairman of the Federal Reserve, emerges from his meetings with the Federal Open Market Committee, he addresses the media in that most Delphic of dialects – “Fedspeak.” Like any good central banker, he is careful to preach the piety of price stability. Even if he believes that more inflation could help the US economy, he would be hard pressed to admit it.

His allies on the FOMC, however, have more leeway. Charles Evans, president of the Chicago Fed, for instance, has openly declared his desire for more inflation.

“Given how badly we are doing on our employment mandate, we need to be willing to take a risk on inflation,” he said on October 17. For Evans, this would entail keeping rates near zero until unemployment dips below 7.5 per cent or inflation rises above 3 per cent.

Although 3 per cent inflation would run well above the Fed’s implicit target of just under 2 per cent, Evans is not alone in his appetite for risk. Fed vice-chairman Janet Yellen and Boston Fed president Eric Rosengren also endorsed Evans’ proposal. Even Fed Governor Daniel Tarullo, who seldom addresses the public, recently encouraged additional monetary easing.

This rhetoric about the trade-off between inflation risk and growth reminds me of the early 1960s, a time when economists believed in the Phillips Curve: the idea that higher levels of inflation can reduce unemployment.
If the Fed is thinking about the Phillips Curve, that tells me that QE3 is on the way.

One can’t rule out QE4 or QE5, either. Though additional stimulus may arrive in a myriad of forms and labels, one thing is clear: the era of unconventional monetary policy is far from over. In fact, we may have only seen the opening act. Unlike the European Central Bank, which has a single mandate – price stability – the Federal Reserve seeks price stability and full employment. It’s not inflation the Fed wants. It wants jobs.

Here’s how the Phillips Curve comes into play. In 1958, a New Zealand–born economist named William Phillips published research on the relationship between unemployment and the rate of change of wages. By studying British economic data between 1861 and 1957, he found that a burst of inflation brought higher nominal wages.

When nominal wages rose faster than producers increased prices, consumers felt wealthier. The wealth effect spurred near-term consumption and higher nominal gross domestic product, leading to a decline in unemployment.

Intuitive and empowering, Phillips’s theory quickly spread from academia to execution. When John F. Kennedy took office in 1961, unemployment was 6.9 per cent and inflation 1.4 per cent. So Kennedy cut corporate taxes, and the Fed eased. By 1967, inflation and unemployment had converged at 3.8 per cent. It was a halcyon day for economists.

This dreamy state, however, was shortlived. The notion that inflation and unemployment were inversely correlated collapsed during the 1970s, when both went up. In studying why things went awry, economists learnt that the Phillips Curve works during periods of stable inflation expectations.

In order to get a wealth effect, incremental price increases must exceed upward adjustments to inflation expectations. Once both producers and consumers expect prices to rise, the wealth effect vanishes, along with its ability to spur nominal growth.

With inflation expectations unglued, actual inflation loses its punch, and the inverse relationship with unemployment breaks down. This is what happened during stagflation in the US during the 1970s. By the mid-1980s, the theory that inflation could permanently boost employment had been debunked.

Although it may not hold over long periods of time, the Phillips trade-off can work in the short run, especially when inflationary expectations are well anchored. In fact, with unemployment high and inflationary expectations low and declining, the current economic climate might be perfect for a Phillipian experiment. Five-year expectations for US inflation are below 1.5 per cent, down nearly a full percentage point since April.

This is why I believe some of Bernanke’s cohorts are suggesting that a bit more inflation, at 1.6 per cent in the US, would help to ease the nation’s 9.1 per cent jobless rate.

With renewed faith in the Phillips-Curve trade-off, the Fed is likely to pursue a period of higher inflation in hopes of reducing unemployment. In the short run, it probably works, but a prolonged dependence will lead us to the same end: stagflation. No matter. The implicit return of the Phillips Curve to Fed rhetoric sends a strong message to investors: if the Fed secretly wants a little more inflation, it will get it one way or another.

That’s not necessarily all bad for the US. In the near term, the moral of the story is what I’ve been preaching for some time now: the rising tide of liquidity will buoy asset prices, especially US equities.

Scott Minerd is chief investment officer at Guggenheim Partners

Copyright The Financial Times Limited 2011.