This is the second part of a two part series on the macroeconomic implications of the Fed’s regime change. Here, we take a look at the Phillips Curve and the Taylor Rule with respect to the Fed’s new outlook on inflation and unemployment.

By Aidan Levi-Minzi

About three weeks after The Fed’s announcement of a new outlook of “lower for longer” interest rates and a less restrictive policy on inflation, Jerome Powell solidified his claims by laying out the framework that the central bank will follow over the next few years. The chairman confirmed that they will maintain lower interest rates through 2023 and continue their massive efforts of quantitative easing. The reason for this change in policy, according to Powell, is to help return the labor market back to its natural rate, all the while allowing inflation to rise above the predetermined 2% level in order to offset its stubbornness to rise above 1.75% over the past two years. 

There are a few major macroeconomic trends that are affecting the United States today.. The first, and most obvious, is the Coronavirus pandemic, which has given quite a nasty blow to GDP and unemployment. There are also rising tensions, once again, between the United States and China, which have developed into a chess game of monetary policy and trade restrictions. Finally, there is an election coming up, the likes of which could see one of two very different political ideologies, especially with regards to the economy (although, Trump and Biden have a similar outlook when it comes to dealing with China). All of these current events have led to increasing unemployment and extremely low inflation, which means the Fed is a long way off its goal of reaching natural unemployment and inflation above 2%. Still, it is important to understand how this new change in policy will look in the models we have today, and how we may have to change these models for future use. 

This piece looks to review certain economic theories in order to more accurately portray modern macroeconomic trends in an academic setting. It is not intended to critique the work of the Fed. 

Before diving into these models, it would be beneficial to take a closer look at two different philosophies of economic thought. While there are numerous schools of economics, the two that apply most to the American economy are Monetarist, or classical, and Keynesian. Monetarists believe that the money supply is what controls the economy. The Fed’s control over the money supply gives them complete control over both inflation and interest rates, and that will in turn affect unemployment and output. Monetarists usually have a distrust of central banks, and believe that their involvement in monetary policy are what cause economic fluctuations and downturns. Keynesian economics, on the other hand, is a school of thought that focuses more on the laws of supply and demand. While the money supply is an important aspect, it is the effect it has on supply and demand that truly makes a difference in the economy.  While both of these philosophies look to answer a similar question, they disagree on how interest rates and the money supply are correlated. A Monetarist would say that an increase in the money supply would immediately lower interest rates, while a Keynesian would argue that it takes time for the changing money supply to actually make a difference. This comes down to the velocity of money, which is a measure of how quickly money is moved. Monetarist theories fall under the assumption that the velocity of money is constant, which makes sense given that it is the most liquid asset there is. However, this is not necessarily true.

This chart shows the velocity of money since 1959. When Miton Friedman, the father of Monetarist economics, won his Nobel Prize in 1976, velocity was a seemingly constant measurement, hovering around 1.7-1.8. Over the past three major recessions (the 2001 dot-com bubble, the 2008 global financial crisis, and the 2020 Coronavirus), have all seen a major reduction in the velocity of money. Money velocity is an integral part of any macroeconomic model, and it is the reason why this article will be using the Keynesian approach when dissecting the Fed’s new policy. 

The Federal Reserve explained that they will be implementing their new strategy by keeping interest rates low through 2023. With that in mind, the Phillips curve is a theory that has been used by the Fed for the past 40 years to analyze the relationship between inflation and unemployment. The equation is as follows:

inflation = expected inflation + 𝚽(Y_t – Y) + v_t

In this equation, Y_t – Y measures how output has fluctuated away from its natural level, is inflation’s reaction to that fluctuation, and v_t is any sort of exogenous supply shock (which would be helpful if, for instance, an oil cartel decided to jack its prices, but for these purposes, we are more interested in a shock to demand. While this is the original equation, the Fed has gone on to substitute the deviation of output from its natural level to that of unemployment from its natural level. This is a concept known as Okun’s Law, which states that short-run fluctuations in output (or GDP) and unemployment have a strong negative correlation. When GDP is above its natural level, then unemployment is below its natural level. It is also easier for the Fed to measure unemployment than GDP. So, in simpler terms, inflation is dependent on the consumers’ expected inflation and unemployment.

The above graph takes a closer look at the actual effect that unemployment has on inflation, which is represented by the coefficient 𝚽. Here, inflation (orange) has a clear correlation with shifts in GDP (blue). That correlation took a sudden turn during the past three months, where GDP took a massive dip, yet inflation shot up. The Federal Reserve did an excellent job of curbing a recession that could have been much worse by increasing the money supply through its stimulus checks and quantitative easing. However, this means that our coefficient is suddenly much lower than it has been in the past, and that inflation is now influenced solely by expected inflation and shifts in demand according to the Phillips curve. In practice, this is not how inflation is determined, meaning that this theory may not be as useful to economists as it has been in the past.

Another macroeconomic tool used to measure monetary policy is the Taylor Rule. This is essentially an extension of the Phillips curve, but instead provides the optimal interest rate that the Fed should seek to implement. Here is the equation to the Taylor Rule:

Nominal Fed Funds Rate = Inflation + r* + 0.5 (inflation – inflation*) + 0.5 (GDP Gap)

Again, Okun’s Law allows us to use unemployment instead of the GDP gap. There is also r*, which is the natural rate of interest, and inflation – inflation*, which is the difference between current inflation and target inflation. This equation assumes that interest rates should be weighted by the GDP gap and inflation equally. Under this assumption, here is what the Taylor Rule (blue) says the Fed (orange) should do:

There are a few things to consider here. The first is that the Fed had followed, to some extent, the suggestions of the Taylor Rule until the 2008 Global Financial Crisis, which implied that the Fed should actually have negative interest rates. Ever since, the two have not been able to meet at a constant. There are different theories as to why. Some economists believe that the Fed needed to undershoot rates over the past few years in order to offset the period during the crisis when they were overshooting them in order to help the economy recover. Others argue that the natural rate of interest, which is usually assumed to be 2.0%, has fallen, and that the rule needs to be updated. 

Under the Fed’s new policy, there are a few things that need to change about our equation. In this model, we will use an updated measurement of the natural rate of interest, and we have changed the target interest rate to 2.5% to compensate for the Fed allowing inflation to run above its normal 2% target. Most importantly, the weight given to the inflation rate has been dropped from 50% to 20%, as the Fed has said they are more interested in controlling the unemployment gap than they are in inflation. With these new assumptions, along with the fact that inflation should stay low thanks to an increasing money supply, here is the new Taylor Rule:

Here, the Taylor Rule again suggests a (very) negative interest rate today, and continues to see rates below 0.08% even as the GDP rises and unemployment falls. 

One final note worth adding is one of a bit more cynicism. The last time the United States Federal debt exceeded 100% of GDP was after WWII. The president at the time, Harry S Truman, passed the Treasury-Fed Accord of 1951. Truman thought that the only way for the US to pay off its debts was to increase inflation. If this sounds a bit like seigniorage, it’s because it is. But when the government is in this much debt, there isn’t much of a choice for policymakers. The Fed is independent from the three branches of government only in that they do not need the approval of the Executive branch to make decisions. They are still tied to the government in that they are responsible for maintaining its budget. Either way, macroeconomic policy and trends are in need of an update. □

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Work Cited

1. Image source
2. Forsyth, R. (2020, 9 17). What the Federal Reserve’s Latest Move Means for Investors. 
3. Barron’s. https://www.barrons.com/articles/what-the-federal-reserves-latest-move-means- for-investors-51600294247?mod=hp_columnists
4. Federal Reserve Bank of Atlanta. (2020, 10 1). Taylor Rule Utility. frbatlanta.org. https://www.f rbatlanta.org/cqer/research/taylor-rule#:~:text=The%20Taylor%20rule%20is%20an,output%20gap%20or%20unemployment%20gap
5. St. Louis Fed. (2020, 9). stlouisfed.org. https://fred.stlouisfed.org/series/GFDEGDQ188S#0
6. Siegal, L. b. (2013). SOMETIMES THERE REALLY IS A WOLF: INFLATION AND BOND MARKET HISTORY AND PROSPECTS. AJO.