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Originally published Tuesday, October 10, 2006 at 12:00 AM

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Nobel winner helped shift Fed policy

Columbia University professor Edmund Phelps won the Nobel Prize in economics Monday for his work explaining the relationship between inflation...

Washington Post

Columbia University professor Edmund Phelps won the Nobel Prize in economics Monday for his work explaining the relationship between inflation and unemployment, producing theories that helped revolutionize the way the Federal Reserve and other central banks conduct interest-rate policy.

In a series of papers in the late 1960s and early 1970s, Phelps, 73, challenged the prevailing belief that policy-makers could lower the nation's long-term unemployment rate by accepting higher inflation.

That misguided notion contributed ruinously to Federal Reserve policies of the 1970s, which allowed easy credit to fan inflation to double-digit levels. The result was high inflation and high unemployment, a combination that came to be called stagflation.

"It certainly changed thinking about inflation and unemployment," Phelps said Monday. "It must have had significant effect on thinking about the benefits and costs of various government policies. Easy-money policies are a no-no. In the mid-1960s, when I was beginning to write about this, easy money was fine."

Paul Samuelson, a professor at Massachusetts Institute of Technology who in 1970 became the second recipient of the Nobel economics prize, said Phelps' work helped shape the thinking of the current generation of central bankers.

"We all understand today, because of work by Ed Phelps, that you can't just, by raising wages, bring unemployment down to an extreme limit, because it becomes self-defeating," Samuelson said Monday.

Today, some Americans can probably thank Phelps for their jobs. His work is one key reason Fed policy-makers now seek to achieve both low unemployment and low inflation, no longer believing they have to choose between them. That strategy has largely worked for the past 15 years.

The Royal Swedish Academy of Sciences announced the prize Monday in Stockholm, saying Phelps' theories "radically changed our perception of the interaction between inflation and unemployment" and helped explain the abysmal economy of the 1970s.

"He's one of the people who's had some really long-lasting ideas," said Thomas Schelling of the University of Maryland, who won the economics Nobel last year and who taught Phelps at Yale University in the late 1950s. "He has had ideas other people didn't have, and maybe no one else would have had."

Alan Blinder, former vice chairman of the Fed, said Phelps' insights, together with related work by Nobel Prize-winning economist Milton Friedman, are "absolutely central and fundamental to the way" the Fed and most other central banks adjust interest rates to guide economic growth and control inflation.

Phelps' work challenged an accepted economic model known as the Phillips curve, named after an economist from New Zealand, A.W. Phillips. It depicted a long-term trade-off between inflation and unemployment, and it implied that policy-makers could permanently reduce unemployment if they were willing to accept a higher level of inflation.

Phelps acknowledged a short-term relationship, as when high joblessness lowers demand for goods and services, making it hard for companies to raise prices, or when low unemployment boosts demand and gives businesses more pricing power. But Phelps added that inflation also depends on companies' and consumers' expectations of future price increases. People tend to expect inflation to continue at about the current pace, and they often act in ways that make those expectations self-fulfilling, as occurred during the 1970s when price increases and inflationary expectations soared.

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The original Phillips curve failed to explain the experiences of the 1970s, when inflation and unemployment were high, and the late 1990s, when inflation and unemployment were low.

Ultimately, Phelps found, there is no trade-off over the long term, which the Swedish Academy called "one of the most influential ideas in macroeconomics over the past 50 years."

Phelps developed a revised model, called the expectations-augmented Phillips curve. This model is widely used by Fed economists and other central bankers to determine the economy's short-term, natural rate of unemployment. When joblessness is below that level, inflation pressures intensify; when unemployment is above that level, the reverse occurs.

Many Fed policy-makers believe today's unemployment rate of 4.6 percent is at or slightly below the natural rate. The policy-makers are worried the tight labor market might feed inflation, which has been running at a worrisome level for much of the past year.

In recent years, Phelps has written on the causes of economic booms and the persistence of poverty in the United States. After Hurricane Katrina devastated New Orleans last year, he wrote in the Wall Street Journal that the events there "pointed to a tragic flaw of a great nation still in denial about impoverished workers among its own citizens and in a muddle about its causes and cures."

More recently, Phelps has been looking into whether policy-makers at the Fed can set a specific target level of inflation and work to achieve it.

"I'm a little bit friendly toward inflation targeting," Phelps said. Still, he said he has been "a little bit bothered by the fact that the usual formulations of inflation targeting are kind of unrealistic."

Such formulations "tend to assume the policy-maker knows all sorts of things he couldn't possibly know," such as what is the "natural" level of interest rates that perfectly balances growth and inflation.

Inflation targeting "is what I've been working on for the past four weeks or so," he said.

Phelps has written frequently on the notion that "dynamism" — the creation and development of new ideas — was the key to fostering growth over the long run.

"That's a matter of the entrepreneurs having lots of good ideas and financiers having the savvy to choose well among those competing ideas and decide which ones to back," he said today. "Good entrepreneurship plus good financiership equals dynamism."

Phelps told the New York Sun in 2004 that Europe's lack of dynamism accounts for "everything we read in the paper — low employment, low labor participation, relatively low productivity, and, I think, an unenthusiastic attitude toward work and business."

The $1.4 million prize that Phelps won Monday was established in 1969 by Sweden's central bank and is formally known as the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.

Material from Bloomberg News was used in this report.

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