ANALYSIS--Labor/inflation theory
nears last breath
By Isabelle Clary
NEW YORK, May 3 (Reuters) - It seems like just about
everyone is working in the United States, except the Phillips
Curve -- a once-popular economic theory that could have cost
millions of Americans jobs if Federal Reserve Chairman Alan
Greenspan did not have his doubts about it.
The Phillips Curve theory, named after British economist A.W. Phillips, holds that wages rise faster
when demand for labor is strong -- as should be the case in America where the jobless rate today is
at a 29-year low of 4.2 percent.
However, unemployment and inflation have steadily fallen hand in hand over the past four years.
''I must say, I'm blown away by the last two ECI reports,'' admitted former Fed Vice Chairman
Alan Blinder, commenting on the broad measure of U.S. labor costs known as the Employment Cost
Index.
The ECI report issued last week provided further evidence that life does not imitate theory. U.S.
wages and benefits edged up by 0.4 percent in January-March, the smallest increase since the series
started in 1982. Over the past six months, the ECI rose at an annualized rate of just 2.2 percent.
''That 2.2 percent nominal increase, that's really extraordinary, very surprising. To say the Phillips
Curve is dead is too strong, but it certainly took a serious wound,'' said Blinder, once a hard-core
Phillips Curve believer, who now teaches economics at Princeton University.
''The Phillips Curve certainly is bed-ridden. If we have another year of these kind of numbers, we'll
go to the funerals,'' Blinder added.
David Resler, a managing director at Nomura Securities International and a former Fed economist,
stressed Phillips himself never made the leap of faith between unemployment and inflation -- let alone
said a central bank should raise interest rates solely to put people out of work.
''Phillips basically observed an inverse correlation between the unemployment rate and wages
acceleration when he studied in the 1950s nearly a century worth of wages and employment data
going back to 1861,'' Resler said. ''Phillips himself did not offer any theory about broad inflation,
others did.''
Some experts, like Nobel-Prize winner Milton Friedman, drew from Phillips's observations the
notion of a natural rate of unemployment -- meaning that, for one reason or another, there always are
people who are unemployed.
''From there, others inferred it's possible to identify an unemployment rate level that would predict
future inflation because all goods and services prices would go up from there. They were proven
wrong in the recent years,'' Resler added.
The U.S. central bank never endorsed any economic theory, and certainly not one that is running
counter to its dual mandate for stable prices and maximum employment.
In fact, simultaneous dips in inflation and unemployment rates have allowed the Fed to lower the
federal funds rate six times and raise it only once since early 1995.
New York Fed President William McDonough has said that lowering interest rates and giving
growth a chance required courage among U.S. policymakers because this flew in the face of theories
staunchly supported in academia.
''Tight labor markets'' remains the buzz words for a Fed that professes caution about inflation.
Financial markets, at times, equate this with threats of higher interest rates but, as one trader put it,
''the Fed is not about what they say, but what they do and they don't raise rates unless needed.''
William Dudley, director of economic research at Goldman, Sachs and Co., warned that favorable
factors that helped push U.S. inflation lower -- such as the slide in commodities prices last year --
may reverse themselves and revive theories that link low unemployment and inflation pressure.
''The bad news is that the best of the inflation story is behind us. The good news is that things will
get worse very slowly and give Greenspan plenty of time to react,'' Dudley said. ''Greenspan is not
tied down to any kind of economic model; he's very data-driven. Only when the data change will he
think this is the right model and do something.''
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