Fed Rate Debate: New Twists in Old Path

Fed Governor Lael Brainard said weakness overseas emanating from China suggested risks to the U.S. economy were ‘tilted to the downside.’ ENLARGE
Fed Governor Lael Brainard said weakness overseas emanating from China suggested risks to the U.S. economy were ‘tilted to the downside.’ Photo: Andrew Harrer/Bloomberg News

The Federal Reserve’s framework for thinking about inflation may be starting to shift, making the path of monetary policy even more uncertain.

Remarks from two Fed governors this past week cast further doubt on whether the central bank will raise rates this year. In a speech Monday, Lael Brainard said weakness overseas emanating from China suggested risks to the U.S. economy were “tilted to the downside.” And, after pointing to how that weakness has been pushing inflation lower, Daniel Tarullo on CNBC Tuesday said he didn’t “expect it would be appropriate to raise rates this year.”

The dovish comments put a high hurdle on the Fed raising rates at its December meeting, never mind its coming October one—absent a clear improvement in recently middling economic data, Chairwoman Janet Yellen would risk two dissents from core members of the Fed’s policy-setting committee if she pushed to tighten.

For investors, though, it may be what the governors had to say about the relationship between the unemployment rate and inflation that is most important.

When unemployment falls, it is a sign available workers, and often other resources, are becoming scarcer. So wages and other prices climb. This tradeoff between lower unemployment and higher inflation, called the Phillips curve, lays at the heart of economic models used by the Fed.

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But both Ms. Brainard and Mr. Tarullo questioned the ability of Phillips-curve models to forecast inflation. They noted the unemployment rate has been falling steadily, yet inflation has run well below the Fed’s 2% target.

Ms. Brainard: “To be clear, I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation.” Mr. Tarullo: “I do think under these circumstances it’s probably wise not to be counting so much on past correlations—things like the Phillips curve which haven’t been operating effectively for 10 years now.”

A paper presented in August by two former Fed economists at the Federal Reserve Bank of Kansas City’s annual retreat in Jackson Hole, Wyo. provides backing for the governors’ views. Jon Faust and Eric Leeper argued the relationship between measures of economic slack, such as the unemployment rate, and inflation has never been very tight, and that standard measures of slack have never shown any real predictive power for where inflation is heading.

This doesn’t mean there isn’t some unemployment rate where inflation will heat up, says Mr. Faust, now at Johns Hopkins University. Rather, there are so many other factors that influence inflation it’s impossible to know what that unemployment rate might be.

Although the paper may have helped convince Ms. Brainard and Mr. Tarullo to look past the Phillips curve, the same is probably not yet true for Ms. Yellen. While acknowledging the problems with the Phillips curve in a speech last month, she nonetheless used it to explain why she believed inflation will move toward the Fed’s target.

As investors try to handicap the Fed’s course, and so the path of things like bond yields, the debate over the Phillips curve is anything but academic. If anything, it makes the Fed’s path even less predictable and means it will take a clear pickup in inflation, or an unemployment rate well below the current 5.1%, to get the Fed moving.

Write to Justin Lahart at [email protected]


WSJ.com: Markets

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