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Bonds Are Still Living in Phillips Curve World. The Fed Isn’t.

Bonds Are Still Living in Phillips Curve World. The Fed Isn’t. The yield on 10-year Treasuries surged as much as 17 basis points after a strong jobs report, signaling the markets are still taking their cues from an economic idea that’s been around since the 1950s. The Phillips Curve, a key theory in economics, suggests that there is an inverse relationship between unemployment and inflation. In other words, as unemployment falls, inflation rises, and vice versa. This concept has been central to monetary policy for decades, with central banks using it to guide interest rates and inflation expectations. However, in recent years, this relationship has weakened, leading some to question the continued relevance of the Phillips Curve. Despite that, the markets still seem to believe in its power, as evidenced by the reaction to the jobs report. The strong jobs report showed that the U.S. economy added 943,000 jobs in July, well above economists’ expectations. This suggests that the labor market is recovering faster than anticipated, which could potentially fuel inflationary pressures. Following the release of the report, the yield on 10-year Treasuries, a key benchmark for borrowing costs, spiked. This indicates that investors are anticipating higher inflation and adjusting their expectations accordingly. The reaction from the bond market aligns with the traditional thinking of the Phillips Curve. As the labor market tightens and unemployment falls, the theory suggests that inflation should rise. In response, bond yields increase to compensate for the expected rise in inflation, as investors demand higher returns to protect against eroding purchasing power. However, the Federal Reserve seems to be operating in a different world. Despite the strong jobs report, the central bank remains committed to its dovish stance, suggesting that it is not overly concerned about inflationary pressures at the moment. The Fed’s focus on achieving maximum employment and its willingness to let inflation run above its target of 2% indicate that it is not following the traditional Phillips Curve framework. Instead, it appears to be prioritizing economic recovery and ensuring that the labor market rebounds fully before tightening monetary policy. This divergence between the bond market and the Fed highlights the ongoing debate about the relevance of the Phillips Curve. While the bond market is still heavily influenced by the theory, the central bank seems to be adopting a more nuanced approach. One possible explanation for the divergence is that the Phillips Curve may not be capturing the full complexity of the labor market and inflation dynamics. Factors such as technological advancements, globalization, and changes in worker bargaining power may be influencing these relationships in ways that are not fully captured by the traditional framework. Another factor to consider is the impact of unconventional monetary policy measures, such as quantitative easing, on inflation dynamics. The massive bond-buying programs implemented by central banks in response to the global financial crisis and the Covid-19 pandemic may have distorted the traditional relationship between unemployment and inflation. Additionally, the Fed’s commitment to forward guidance and its efforts to be more transparent in its decision-making process may have also contributed to the discrepancy. By clearly communicating its intentions and signaling that it will not be quick to raise interest rates, the central bank may be influencing market expectations and dampening the impact of the jobs report on bond yields. Regardless of the reasons for the disconnect, it is clear that the bond market is still living in a Phillips Curve world. The reaction to the jobs report suggests that investors are still relying on this concept to guide their investment decisions. However, it remains to be seen whether this reliance will continue to hold true in the face of changing economic dynamics and the Fed’s evolving approach to monetary policy. As the labor market continues to recover and inflationary pressures build, it will be interesting to see how the relationship between the bond market and the central bank evolves. In conclusion, while the bond market seems to still believe in the power of the Phillips Curve, the Federal Reserve is taking a different approach. The divergence between the two highlights the ongoing debate about the relevance of the theory in today’s economic environment. As the economy continues to recover and inflation expectations evolve, it will be important to reassess the validity of the Phillips Curve and its implications for monetary policy.

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