With New Monetary Policy Approach, Fed Lays Phillips Curve To Rest

One of the fundamental theories of modern economics may have finally been put to rest.

In the several years before the coronavirus pandemic took hold of the global economy, 🏦Federal Reserve policymakers watched as the U.S. unemployment rate fell lower and lower and waited for the jump in inflation typically associated with such a tight labor market.

The expectations were based on a rule that has shaped decades of monetary policy decisions: the Phillips curve, or the concept that inflation tends to rise when the unemployment rate falls, and vice versa.

But the inflation that Fed officials anticipated never arrived, and in a monumental speech delivered on Thursday, Fed Chair 👤Jerome Powell announced that the U.S. central bank’s policymakers are done waiting.

The Fed chief, speaking during the Kansas City Fed’s annual conference, unveiled the central bank’s new approach to monetary policy, which puts more emphasis on shortfalls in employment, and less weight on the fear that low unemployment could spark higher inflation.

“The conditions in the economy have changed to such an extent that this upwardly sloped relationship between inflation and employment has now changed,” said Joseph Brusuelas, chief economist for RSM. “Decades of thought at the Fed are now being pushed aside.”

With its landmark policy shift, the Fed is putting new weight on bolstering the labor market and less on inflation, promising to aim for 2% inflation on average over a period of time rather than using that figure as a hard annual target, as it had done since 2012.

With their new approach, Fed officials are essentially saying they are no longer worried about the unemployment rate falling too low. Now that inflation expectations are anchored at low levels, the economy has room to keep adding jobs.