Jefferies

Economics and Strategy

Goldilocks Just Keeps Kicking the Phillips Curvers in the Teeth

David Zervos, Chief Market Strategist

The U.S. unemployment rate released on June 1 hit a cycle low of 3.8%, a level that was last seen in April 2000, at the very end of the Goldilocks era. Prior to that you would have to go all the way back to the “golden age” of the late 1960s in order to find rates this low. But that said, the comparison today with April 2000, or the late 1960s, breaks down quite quickly once we consider current inflation levels.

In April 2000 CPI inflation was 3.1% – 60 basis points higher than it is today. And during the February 1966 - January 1970 period, when the unemployment rate had a 3 handle for all but one month, the average inflation rate was 3.9%. In fact, it was only in April 1967 that an employment rate of 3.8% or less coincided with an inflation rate of 2.5% or less. So what we witnessed last week in terms of inflation and unemployment combinations is one of the most unusual phenomena in modern economic history. But more importantly, it continues a more general pattern of violently contradicting the primary tenet of modern Keynesian economic theory, the Phillips Curve.

The concept that inflation will rise as unemployment falls is preprogrammed into every major central bank and street economic model. And it is like a disease that can cause policy makers and portfolio managers to make serious mistakes. As I have argued for quite some time in these notes, there are powerful drivers of disinflation affecting the U.S. economy. And these have been, and will likely continue to be, dominating the fatuous partial-equilibrium storyline that the Phillips Curve brings to the table. Focusing on the positive supply-side drivers of technological advance, corporate tax reform, and deregulation, along with the negative demand-side driver of demographics, will lead to a much better understanding of both the economy and financial markets

One can only hope that with the U.S. unemployment rate at 3.8%, average hourly earnings growth at 2.7%, and CPI inflation at 2.5%, the leaders of central banks won’t fall prey to the deeply entrenched Keynesian interests of their staff or street economists. These folks have built up a cabal over many decades that principally aims to keep their misguided Keynesian human capital relevant (and compensated). The sooner one figures that out the better.

Now to be sure, the data have been highly uncooperative with the cabal view for a while now. But these folks are persistent, and they have twisted and shifted the Phillips Curve in every possible way to try to salvage their junkyard of ideas. But after last week the jig may finally be up. A 3.8% unemployment rate with no sign of material inflation risk developing is a near fatal blow. Goldilocks has surely arrived in 2018. And while the Phillips Curvers are all lying beaten on the ground whining about inflation risks with their last dying gasps, she just keeps kicking them harder and harder. Go get ‘em Goldilocks! Good luck trading.