Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services

  • The US equity market, represented by the S&P 500 index, rose 1% for the week ending July 28.
  • This week, inflation data showed further declines, wage growth softened, and the employment picture remained strong, adding more evidence to support the soft-landing scenario for the US economy.

The Federal Reserve raised its overnight target interest rate on Wednesday by 0.25%, to a range of 5.25% to 5.5%. In prepared comments at his press conference, Fed Chair Jerome Powell stated that “for inflation to reach 2% the economy will likely require a period of below-trend growth and some softening of labor market conditions.”

Most economists believe there is a tradeoff between unemployment and inflation – that is, for inflation to decline, unemployment must rise. This tradeoff is known as the Phillips curve, named after the New Zealand economist who first alluded to it. The Phillips curve became famous in the 1950’s and 1960’s, but after the US experienced high unemployment and high inflation in the 1970’s it came under intense criticism. Today, most economists do not ascribe to the original version of the curve – but its core message remains influential, as seen in Mr. Powell’s comments above.

The economic data so far in 2023 does not fit the traditional Phillips curve relationship between unemployment and inflation. Inflation has been declining and unemployment is at multi-decade lows, all while wage growth is moderating and economic growth is picking up.

Dario Perkins, head of Global Macro at TS Lombard and a former economist for the UK Treasury in the late 1990’s, noted this week that “the Phillips curve has failed to ‘work’ throughout my entire professional career. Sometimes the relationship between inflation and unemployment is flat, sometimes steep, sometimes inverted, sometimes it does the loop-to-loop."

Mr. Perkins postulates that one reason for adherence to the core idea of the Phillips curve is to help “reconcile the competing demands we have placed” on the Federal Reserve, which has one main policy tool (the interest rate) to deliver full employment and low inflation. The Fed must believe those are related in some way or it faces an impossible task.

Interestingly, in the Q&A session after his prepared comments, Fed Chair Powell seemed to be open to the idea that inflation can fall without rising unemployment. He sees the strong economy and labor market as “a good thing”, and that it is a “blessing” that there has been disinflation. Mr. Powell does not necessarily see the need, nor does he want, higher unemployment to bring down inflation.

Mr. Powell and the Fed appear to be inclined to give the green light to the economy: continued growth and low unemployment with steady disinflation may not mean more interest rate hikes.

Markets reflect a belief that the Fed will achieve its goals without breaking anything with high interest rates (apart from a few banks). Since the Fed began raising rates in March 2022, the S&P 500 is up 6%. Rather than an impending recession, the main risk for markets could instead be an accelerating economy into late 2023 and 2024, rekindling inflation. That could lead to a Phillips-curvy Fed approach with greater odds of more rate hikes into next year.z

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