What Modern Monetary Theory has to say about the US Fed’s change of strategy

In his speech of August 27, 2020, Jerome Powell, Chairman of the U.S. Federal Reserve effectively laid to rest the Phillips curve which articulated a trade-off between inflation and unemployment rates.  This hypothesis had opened up a possible policy tool for governments by which they could use an unemployment buffer to control inflation.

Price stability, or in other words, a non-accelerating inflation rate at a reasonably low level of about 2 percent for advanced countries and around 4 percent for developing countries, was considered a crucial element in enabling the efficient functioning of a private sector-led market system to achieve high growth rates in aggregate output (GDP). However, a contradiction emerges.  High GDP growth rates would at some point cause shortages in the labour market, driving up wages and consequently induce an acceleration in inflation rates as the wage-price spiral sets in. To prevent such a possibility an independent central bank could utilize monetary policy by raising interest rates to contain consumption and investment demand that slows down growth or even contracts the economy, thereby generating unemployment so that an overheated labour market cools down and wages don’t rise or even fall so as to lower the inflation rate.

The use of this policy to tackle inflation was used aggressively by the Federal Reserve under Paul Volcker.   The oil price shocks of the 1970s had induced inflation rates to accelerate in the US from about 6 percent in the beginning of 1978 to around 10 percent by the end of the year.  To rein-in the “Great Inflation”, Volcker categorically decided that “the standard of living of the average American has to decline.”  Put simply, wage increases had to be brought under control and for this unemployment had to increase.  He raised interest rates (the Feds Funds rate) from about 11 percent when he took charge in 1979 to 19 percent in 1981. The consequence on unemployment was brutal.  From just about 4 percent in 1978, US unemployment rate shot up to 11 percent by 1981.  Volcker had effectively tamed labour with a severe recession.  The foundation for neoliberal macroeconomics had been laid.

In the years following the 2008 Global Financial Crisis (GFC), the US economy witnessed robust GDP growth and at the same time, falling unemployment rates from about 10 percent in 2010 to less than 4 percent in 2019.  Interest rates remained close to zero until 2016 after which they were gradually hiked to about 2.5 percent only to be lowered again since the end of July 2019. Then the pandemic struck and interest rates are back to being close to zero.

Throughout this period, however, it seemed like the significant fall in unemployment rate did not induce a threat of accelerating inflation.  The question then arises as to whether the Fed could continue to let unemployment fall below the estimated natural level of unemployment while, at the same time, let interest rates remain low.  Effectively then the Fed recognised that the Phillips curve and more specifically, the non-accelerating inflation rate of unemployment (NAIRU) may be overestimated so that the inflation expectations may have been “holding down inflation more than was generally anticipated.”

In view of these observed trends, Jerome Powell announced a new monetary policy framework wherein if the Fed notices a fall in the unemployment rate, it will not react with interest rate hikes as long as the average inflation rate over a period of time will not exceed 2 percent.  Moreover, the definition of “average” has been kept blurred as the Fed has not specified a mathematical formula to compute this “average”.

In a nutshell the Fed has moved from inflation targeting to a “flexible form of average inflation targeting” and simultaneously, rather than taking pre-emptive action against “deviations from maximum” employment they now assess “shortfalls from the maximum” and use a greater degree of discretion in their monetary policy response.

Nonetheless, the Fed has not unequivocally withdrawn its Volckerian threat.

“Of course, if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act,” said Powell.

This is a clear assertion that the unemployment buffer stock may have been relaxed but certainly not eliminated.

While Powell identifies some reasons for the breakdown in the Phillips curve such as slowing  population and productivity growth, an aging population and global disinflationary pressures, he does not mention the wide divergence between real wage growth and productivity growth that has taken place since the 1970s nor does he discuss the weakening power and ability of workers to engage in collectively bargaining that has emerged from neoliberal macroeconomic policies – privatization, liberalization (deregulation) and globalization.

For years now, the proponents of Modern Money Theory (MMT) have been pointing out the breakdown of the Phillips curve.  In fact, the political face of MMT, Rep. Alexandria Octavio-Cortez had questioned Powell at a congressional hearing in July 2019 whether the Phillips curve had broken down.  His answer was in the affirmative.  And this was much before the pandemic.  The hearing then articulated a greater role for fiscal policy –greater fiscal space – to address issues of long-term growth, stagnant real wages and unemployment.

Although the recent policy statement by Powell seems like a small victory for labour, MMTers have warned that the Fed is likely to revert to its old ways after the economic crisis unleashed by the pandemic abates.  As proposed by the Australian economist William Mitchell more than twenty years ago, a longer-term solution to achieve full employment with price stability is the implementation of a universal job guarantee (UJG) program wherein a buffer stock of employment (not unemployment) is created to stabilize wages and thereby inflation.  The UJG minimum wage rate serves as nominal anchor for wage rates and the price level.

Sashi Sivramkrishna is an MMT researcher, economic historian and documentary filmmaker. Views are personal.