A central proposition in the Phillips curve view of the inflation process is that prices are marked up over productivity-adjusted labor costs. If that is true, then long-run movements in prices and labor costs must be correlated. If long-run movements in a time series are modeled as a stochastic trend, then the above noted implication of the 'price markup' view is related to the concept of cointegration discussed in Granger (1986), which says that cointegrated multiple time series share common stochastic trends. The evidence reported here shows that time series measuring rates of change in prices and labor costs are cointegrated. Furthermore, this cointegration appears consistent with Granger-causality running from the rate of change in prices to the rate of change in labor costs, but not vice versa as suggested by the 'price markup' view.

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Using real time estimates of output gaps or Greenbook forecasts of the unemployment rate, this article estimates Taylor-type policy rules that predict the actual behavior of the funds rate during two sample periods, 1968Q1 to 1979Q2 and 1979Q3 to 1994Q4. The inflation rate response coefficient is close to unity over the first sub-period and well above unity over the second, suggesting Fed policy violated the Taylor principle during the first period. The adjustment of the funds rate in response to fundamentals is not as rapid during the first period as it is during the second. Together these results support the conventional view that the Fed was "too timid" and "too sluggish" during the late 1960s and the 1970s. Though the Fed smoothes interest rates, the degree of smoothing exhibited is far less than what was previously estimated. The funds rate response to its fundamentals is complete within one year during the first period and within one quarter during the second.

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