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Phillips Curve breaks down, no Fed hikes in foreseeable future

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The Federal Reserve (Fed) will not raise interest rates again this year and it's all because of a breakdown in the Phillips curve. The Phillips curve is all anyone is talking about over at the Fed these days. The Fed turned to it again last week as it raised the benchmark interest rate to a 25 basis point band with a 1 percent floor. The curve is an inverse relationship between unemployment and inflation. If unemployment is low, companies fight over fewer available employees. This pushes employee wages higher. Higher wages mean higher costs for companies which increase prices to cover these costs. This means inflation, on paper. This is the reasoning behind the curve and the Fed is banking on higher inflation, but something is not right.

With the Fed's decision to raise the Federal Funds target rate, the Fed bet that although the Phillips curve has broken down, it will soon catch up. While unemployment fell from 4.7 percent to 4.3 percent, inflation expectations have fallen from 1.9 percent to 1.6 percent. In other words, unemployment has decreased but inflation has also decreased. How and why is this possible? In short, no one really knows, but here are some ideas.

The first obvious explanation is that unemployment has not actually decreased. While the headline unemployment rate keeps decreasing, the participation rate continues to be at near 40-year lows. In other words, the number of Americans that are working relative to the number that can work has not been this low since the Carter administration. The headline unemployment rate does not account for people who have dropped out of the employment market altogether, given up essentially. So while news reports of record-setting low unemployment continue, the reality is, the labor market is not as hot as we may think.

Another potential explanation is that the second industrial revolution is at hand. While the data to support this is still inconclusive, efficiencies in new technologies have made many industries obsolete which has forced employees in these industries to drop out of the labor market completely. This would account for lower inflation rates as costs decrease and also for the continued depression of the participation rate.

Whatever the explanation, lower unemployment has not translated to lower inflation. A premature hiking of interest rates may send the economy into a recession which would increase unemployment and necessitate rate cuts. Why not leave rates where they are instead of risking tanking the economy? The first reason is rates need to be non-zero for the Fed to be able to cut them later on. This means the Fed is trying to raise rates now while the economy can still absorb hikes so that it can decrease them should unemployment or inflation increase rapidly. Seems unnecessary at this point.

The Phillips curve and current Fed actions are obviously not taking place in a vacuum. The Fed has laid out, for the first time, how it will begin to wind down its $4.5-trillion balance sheet. The Fed will begin to allow treasuries and mortgage-backed securities to mature at a rate of $6 billion and $4 billion respectively per month and double these numbers in consecutive months until the total volume of debt being allowed to mature hits $50 billion a month. At this rate, it would take the Fed nearly eight years from now to wind down its balance sheet. However, I've got a feeling it will take even longer.

The European Central Bank attempted a similar program starting in the summer of 2012 for two years, allowing over a trillion dollars in debt instruments to mature. This resulted in a severe shock to eurozone manufacturing and a second "mini-Great Recession." The ECB realized its mistake and had to pump in another $2 trillion to save the common market. The Fed is undoubtedly keenly aware of the ECB's mistake and that's why its schedule is much more relaxed, less than half as fast at its fastest rate of maturities.

In short, the U.S. economy and the global economy in general are in uncharted territory and are as fragile as they are robust. Text book explanations for economics no longer hold in many instances and central banks are guessing how markets will react. In the next year, either the Fed will have realized it has made a grave mistake and quickly cut rates or will adopt a wait-and-see approach. In both cases, don't expect any more rate hikes for the foreseeable future.

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