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Here's the chart that's messing up the Fed

Federal Reserve Chair Janet Yellen recently said that interest rates are likely to rise this year, as the "transitory" effects of falling commodity prices eventually give way to inflation hitting the Fed's stated target of 2 percent.

Yellen also acknowledged that there are some concerns about using the "Phillips curve" — a chart that shows the relationship between declining unemployment, rising wages and inflation — to guide policy.

I have some serious trouble with this curve.

The curve was named after British economist, A.W. Phillips, who studied employment and wage inflation in Britain between 1860 and 1957 and found an inverse relationship between unemployment and compensation. As unemployment fell, wages rose, with employers competing more aggressively for increasingly scarce workers by raising wages.

The increase in wages allowed workers to then bid up prices of goods and services as they, too, competed for increasingly scarce material wants. A wage/price spiral ensued which could only be ended by tighter monetary policy, or higher interest rates, from the central bank.

This model may have had much more relevance in a closed economy, where influences from global labor markets were few, if not entirely non-existent. That is not remotely the case today.

This relationship, despite frequent references to it, and a continued adherence to it as a policy tool, has broken down in recent economic history.

The wage/price spiral of the 1970s was the result of the U.S. abandoning the gold standard in 1971, drastically devaluing the dollar. Wage and price controls were enacted that, ultimately, exacerbated the trend when the lid was subsequently lifted.

In addition, there were two major oil shocks that fueled runaway inflation coupled with monetary and fiscal policy errors that only added to the woes. The ultimate result was "stagflation," a period in which both unemployment AND inflation increased, breaking with Phillips curve orthodoxy.

Conversely, in the 1990s, and since, the economy has exceeded what was believed to be full employment without the accompanying acceleration in wages, save for certain sectors, like high tech during the Internet bubble, or energy jobs, during the most recent "fracking" boom.


Both have since proved temporary influences on the overall level of wages.

Indeed, despite unemployment falling to 5.1 percent, wage inflation has hovered at an annual rate of about 2.2 percent, while overall employment costs have stagnated.

There has been no indication of wages running out of control as unemployment has fallen. The share of unionized labor, which demanded wages be indexed to rising inflation in the 1970s, is not a dominant factor in setting compensation for workers today, broadly speaking.

Outsourcing, both geographically and technologically, has also capped the ability of workers to demand ever-increasing share of corporate costs. (While I do not think this is a good development for the U.S. economy, it is a reality.)

Hence, there is scant danger of a wage/price spiral today, despite falling unemployment, and there is precious little evidence that one is on the horizon.

The Federal Reserve, as early as next month, could begin normalizing interest-rate policy, by raising its benchmark short-term rate by a quarter point, based, in part, on the likelihood that "full employment" will give way to rising wages and, subsequently, rising consumer prices.

While expressing reservations about the Phillips curve effect, the Fed is still using it as a guide in setting policy.

The world is in the throes of deflation. Commodity prices have crashed. There is an abundant oversupply of labor around the world and slack demand for goods and services from Beijing to Brazil.

While the U.S. has been a relative oasis of prosperity, to borrow a term from former Federal Reserve Chairman, Alan Greenspan, it is more subject to deflationary forces exerting themselves on the global, and domestic, economy than inflationary influences.

The markets are telling us that inflation is not only NOT a problem, but virtually non-existent. Meanwhile an ancient curve from 1860-1957 is telling us to worry.

The Phillips curve, for all practical purposes, is dead. The Fed should bury it, along with a variety of other theoretical models and let the real world be its guide.


Commentary by Ron Insana, a CNBC and MSNBC contributor and the author of four books on Wall Street. Follow him on Twitter @rinsana.