The Fed's Thermostat Is On The Fritz

The old, gray Phillips Curve ain't what it used to be. But nobody seems to be paying attention.

As you will recall from Economics 101, the Phillips Curve describes the "trade-off" between unemployment and inflation. Supposedly, if you want less of one, you must take more of the other. When unemployment falls, inflationary pressures are said to rise, because workers in scarce supply gain bargaining power to bid up wages. The higher wage costs are embedded in product prices and passed along to the public. Thus the Phillips Curve.

The Federal Reserve, for the second time in less than two months, has raised short-term interest rates to cool an arguably overheated economy. But today's labor markets bear little resemblance to those of the inflation-ridden 1970s. Unions are severely weakened. Their habitats--regulated and monopolistic industries--have been all but obliterated. In deregulated sectors such as airlines, trucking, and telecommunications, wages are in free fall. Actual foreign competition or the threat of offshore production tempers labor demands. Indeed, the typical "demand" in recent contract negotiations is management's demands for cuts. COLAs--automatic cost of living adjustments--are nearly defunct.

JOB SHIFT. The explosion of so-called contingent work--part-timers, temps, and contract employees--tells the same story. In past business cycles, the fraction of involuntary part-time workers increased during recessions and decreased during recoveries. In this cycle, the proportion of part-timers rose during the recession--and rose again during the recovery. Most job seekers want a full-time, permanent, career-ladder job. That industry has no trouble filling job slots with part-timers and temps underscores a fundamental shift in bargaining power: Despite the recent decline in measured unemployment, there is virtually no wage inflation in the economy.

Deregulation, globalization, heightened competition, and innovation have had a similar deflationary effect on product markets. Cost-cutting pressures are endemic. Companies can no longer easily pass along cost increases. Inflation is a vanishing phenomenon because of customer resistance. Businesses today are much more likely to absorb costs and innovate around them for fear of losing market share if they raise prices. By the same token, in an era of shorter product cycles and multiple, global sources of supply, "capacity utilization" as an indicator of inflationary pressure is outmoded.

Joel Popkin, formerly assistant commissioner of labor statistics in charge of price indexes, has devised his own alternative to the government's capacity utilization index. That index is a relic of an era of standard goods, large, inflexible factories, and oligopolies. Popkin's indicator, called the demand/supply ratio, compares unfilled orders with shipments plus inventory. In the past, his indicator closely paralleled capacity utilization. In this recovery, supposed capacity utilization has tightened, but Popkin's demand/supply ratio shows that industry has no trouble filling orders. That accurately conveys the elastic in an innovative and globalized economy--and calls into question whether the official index signals inflation.

BETTER PRODUCTS. One other factor is the overstatement of inflation in the consumer price index. As innovation has accelerated, some of what shows up as price inflation is really the substitution of superior products. A 486-level computer for $1,100, for one, offers more value than a 286-level computer for $1,000. But it shows up in price indexes as 10% inflation.

All of the foregoing suggests profound structural changes that ought to allow the economy to run closer to full employment without courting inflation. Yet, surprisingly, there has been little work among economists on the dynamics of these shifts. Nor has the Fed revised its conception of how employment and capacity utilization affect inflation.

On the contrary, the consensus among economists is that the "natural rate of unemployment" is essentially unchanged. This is known in the trade as the Nonaccelerating Inflation Rate of Unemployment, or NAIRU (pronounced like the late Indian Prime Minister). Most economists think the NAIRU is above 6%, or roughly the current actual rate of unemployment. In other words, noninflationary "full employment" requires nearly 10 million souls to be jobless. This despite there being no evidence of wage inflation and ample evidence of weakened labor bargaining power.

Outmoded theory keeps the economy in a NAIRU jacket. "Workers lose twice," says Lawrence Mishel, research director of the Economic Policy Institute. "Their wages get slashed, but they don't even get credit for allowing unemployment to drop."

The prophets of competition have won, and the economy should be reaping the rewards. Thanks to the sweeping away of barriers, we have finally attained that holy grail of economic theory--flexible labor markets in which the price and quantity of labor adjusts according to supply and demand. Yet instead of celebrating, the Fed and its allies in the dismal science are needlessly denying the economy noninflationary growth.

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