A recent Bloomberg story raises hope that the Federal Reserve can tame inflation without causing a recession. While there is always a chance that the Fed could engineer a soft landing, before rebalancing your portfolio, it would be wise to take a closer look at the actual research behind the Bloomberg story.
According to the January 2023 Fed study:
The Phillips curve captures the empirical inverse relationship between the level of inflation and unemployment. The reciprocal of its slope, sometimes referred to as the “sacrifice ratio,” represents the increase in the unemployment rate associated with a 1 percentage point reduction in the inflation rate. In this Chicago Fed Letter, we provide evidence that the Phillips curve has steepened in many industrialized countries since the start of the recovery from the Covid-19 pandemic. This suggests a lower sacrifice ratio now than before 2020.
Chart 1 shows the 12-month CPI inflation rate and the civilian unemployment rate at a monthly frequency from January 2015 through December 2022 while Chart 2 displays the same data in a Phillips curve format.
The inflation-unemployment data from January 2015 to November 2016 is consistent with a negatively sloped Phillips curve. During this time, the economy continued to recover from the Great Recession while Fed policy was in a holding pattern. In December 2015, the Fed raised the rate it paid on bank reserve balances from 25 to 50 bps and maintained that rate for a year. It had discontinued Quantitative Easing (QE) purchases, but had not yet begun shrinking its balance sheet. Against the backdrop of this monetary policy, inflation hovered around the Fed’s 2 percent target while unemployment gradually declined.
The data from December 2016 through February 2020 does not show any systematic relationship between inflation and unemployment. The “sacrifice ratio” is 0 even though the Fed was pursuing an active monetary policy. Between early December 2017 and April 2019, the Fed raised the rate it paid on bank reserves eight times to 2.4 percent, before reversing course and decreasing it four times to 1.55 percent less than a year later. The Fed began shrinking its balance sheet from mid-October 2017. The reduction was interrupted when short-term rates spiked in September 2019 and the Fed responded by expanding its balance sheet, adding reserves through February 2020. Over this period, the inflation rate hovered around the Fed’s 2 percent target while the unemployment rate continued to decline, reaching a pre-COVID-19 low of 3.5 percent in February 2020.
The data from March 2020 through February 2022 reflects the onset and recovery from the COVID crisis. The unemployment rate spiked in April 2020 as many states shuttered “nonessential” businesses. City centers became ghost towns as workers telecommuted. The inflation rate declined briefly until federal COVID-19 relief payments began reaching households and businesses in late May 2020.
The COVID-19 inflation began in the second quarter of 2020, fueled by supply-chain bottlenecks, massive federal stimulus payments, and aggressive Federal Reserve monetary policy. Fed QE purchases doubled the size of the Fed’s balance sheet while the Fed reduced short-term rates to near zero by lowering the interest rate it paid on bank reserve balances to 10 bps. The unemployment rate dropped from its peak of 14.7 percent in April 2020. While the inflation-unemployment scatter plot for this period exhibits a steep negatively-sloped Phillips curve, it would be imprudent to base monetary policy on a “sacrifice ratio” estimated from an episode with so many intrusive emergency government measures driving the inflation and unemployment data.
Data from March 2022 to December 2022, a period of aggressive Federal Reserve tightening, shows virtually no relationship between unemployment and inflation. Over this period, unemployment hovered between 3.5 and 3.6 percent, while inflation rose to 9.1 percent in June 2022 before supply chain constraints began to ease and the Fed’s restrictive measures took effect. During this period, the Fed ceased QE operations and began to shrink its balance sheet as assets matured. It aggressively increased interest rates by hiking the rate it paid on reserve bank balances 7 times to 4.4 percent. By December 2022, the 12-month CPI inflation rate had moderated to 6.5 percent.
If one were to fit a Phillips curve regression model to data using the entire period, as did the authors of the Chicago Fed study, one would find a steep negatively-sloped Phillips curve. The large estimated “sacrifice ratio” suggests that the Fed can lower the inflation rate by engineering modest increases in the unemployment rate. But before making any bets, it would be prudent to consider the instability of the “sacrifice ratio” exhibited over the 2015–2022 sample period. Historically, Fed monetary actions predicated on a stable Phillips curve relationship have rarely worked as planned.
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