An explicit bet

By November 2012, the unemployment rate in United States was 7.7% and inflation, as measured through the Personal Consumer Expenditures Index (core), was 1.6%.

The Fed members seemed to agree that unemployment was to high and that they were ready to concede a slightly higher inflation in order to reduce the unemployment rate.

This is how on its December FOMC statement, the Fed decided to undertake a monetary policy which basically increases the quantity of money in the economy. The goal was that more money means more credit and more general activity and, at the end, more employment (less unemployment) and production, even if recognizing a cost through more inflation. But the Fed is more explicit: the statement asserts that a reduction on the unemployment rate is going to be pursued as long as inflation doesn't reach 2.5%

The Phillips curve is a supposed relation between unemployment and inflation. What is the shape of that curve at any point in time? What does it shift (changes the shift) of that curve? Those are empirical questions over which economists have debated for years.

With their very explicit, quantitatively measurable policy, what the Fed members are telling amounts to bet that the Phillips curve has a specific shape, a shape such that lays under the point {unemployment: 7.7, inflation 1.6}. This is so, because only such a curve (drawn as the green curve in the graph), allows to reach an unemployment rate of 6.5% or less before reaching an inflation of 2.5% or more.

However, if the Phillips curve lays over the point {unemployment: 7.7, inflation 1.6}, i. e. if the Phillips curve has a shape as that of the blue curve on the graph, then the Fed is going to reach the 2.5% inflation milestone before reducing unemployment under 6.5%, being therefore unable to reach the undartaken goal of having an unemployment of 6.5% or less with an inflation of 2.5% or less.

Next months and years are going to be really interesting in matching reality against the Fed view on the Phillips curve, is going to be a rarely good contribution to the empirical debate, and is going to give a very clear case study to economics teachers.

Green or blue? Make your bet!