Inflation, Unemployment and the Phillips Curve
 
In 1958, economist A.W. Phillips observed a century-long inverse relationship between wage rates and unemployment in the U.K.  In 1960, noted U.S. economists Samuelson and Solow took Phillips’ original idea and made the link between inflation and unemployment quite specific; that is, “when unemployment is low, inflation is high, and vice-versa.”  This idea became known as the Phillips Curve; the “curve” shows a strong relationship such that when the historical data are set out on a graph with one axis labeled unemployment and the other inflation, there is a close fit between low unemployment and high inflation, and vice-versa. Intuitively, this makes sense: in a stable world where economic growth is occurring but there are few people unemployed, wages rise rapidly as employers bid up the price of the scare labor resource.

This has been a fundamental guiding economic theory used by the Federal Reserve for decades to set interest rates.
 
But according to a new study by the Philadelphia Fed’s top-ranking economist the Phillips Curve Doesn’t Work!  Specifically, this fundamental principle at the heart of the Federal Reserve’s strategy for setting interest rates over the past three decades has, in fact, been found to be a poor guide for policy makers.

The paper, co-authored by Philadelphia Fed Director of Research Michael Dotsey, shows that forecasting models based on the Phillips Curve, don’t help predict inflation.  Dotsey and Philadelphia Fed economists Shigeru Fujita and Tom Stark wrote, “Our results indicate that monetary policymakers should at best be very cautious in their reliance on the Phillips curve when gauging inflationary pressures,”

Their study is timely. Fed officials have been surprised by a deceleration in U.S. inflation over the past several months despite a continued decline in unemployment, the opposite of what the Phillips curve relationship would predict.

The Philadelphia Fed economists found that rising unemployment was sometimes able to help predict lower inflation, but falling unemployment didn’t help predict higher inflation. They noted that this was particularly the case during the 1970s and early 1980s when the Fed responded to runaway inflation by raising rates so high that the U.S. economy fell into recession.

They wrote, “Our evidence may indicate that using the Phillips curve may add value to the monetary policy process during downturns, but the evidence is far from conclusive.  We find no evidence for relying on the Phillips curve during normal times, such as those currently facing the U.S. economy.”
 
That report is not at all surprising to the Trends editors or to many others experts.  However, FOMC members seem committed to using the model, despite the study, and despite the obvious lack of empirical support.

Why?  In the 1970s, just a few years after Samuelson and Solow popularized the Phillips Curve idea, the relationship began to no longer work. A condition known as “stagflation,” characterized by high inflation and high unemployment, plagued the economy.  In November 1977, as part of its effort to “help” the economy to get back on track, Congress amended the original Federal Reserve Act to give the Fed a “dual mandate.”  Now, not only is the Fed responsible for price stability, but its policies also have to pursue the promotion of maximum employment. Given this dual mandate, which involves both prices and employment, there should be little wonder why today’s Fed still clings to the simplistic Phillips Curve idea.  It’s the only well-documented framework under which these two issues are intimately related.

As a result, the Federal Reserve under Janet Yellen still acts as if the Phillips Curve is “alive and well.”  For that reason, they assume U3 unemployment at its lowest level in 16 years (at just 4.3%) will ignite inflation’s fires sometime in 2018 and push the inflation rate to at least their 2% target.  And, without further interest rate increases, they claim it will go even higher.

So, because there is a long lag between the Fed’s actions and their impact on the economy, the FOMC members argue that the right thing to do is to pre-empt the risks of inflation running too much above 2% by tightening monetary policy, now.  The trouble with this, of course, is that every major economic metric, except the headline unemployment rate, shows that inflation is not going to be a problem anytime soon.

So, why doesn’t the Phillips Curve currently work the way it did prior to the 70s? There are at least five reasons:

1. Today’s U3 unemployment measure is not the same as the pre-1990s “unemployment rate.” Most economists irresponsibly ignore the definitional changes in the official BLS employment data that occurred in the 1990s.  They behave as if the data from earlier periods is comparable to today’s U3.  In reality, the old definition of “unemployment used in the 60s, 70s, and 80s most closely resembles the U6 definition of unemployment, which includes the marginally employed and those that are part-time because they can’t find full time jobs.  If viewed from that perspective, today’s 8.6% U6 unemployment rate would not elicit an expectation that inflation would be anything but tame using the historical Phillips Curve relationships;

2. Over the past several months, cracks have been appearing in the U.S economic growth engine despite other signs of strength. Slow growth is still the order of the day, even though the 2nd quarter of 2017, saw 3.2% annualized growth.  After an eight-year recovery averaging 1.9%, it’s prudent to assume that a range of tepid growth indicators tell us more than the 4.3% U3 unemployment rate.  So, even if a Phillips Curve type relationship still exists, we shouldn’t expect a return of significant inflation;

3. Over the last 50 years, the U.S. has lost much of its manufacturing base with high wage jobs and it has become a service-oriented economy with more people in lower wage jobs.  Furthermore, U3 counts a part-time job with the same weight as a full-time one.  Both of these factors may be playing an important role in maintaining the tepid pace of wage growth despite low unemployment. Economist David Rosenberg has observed that low wage jobs are now a higher proportion of total jobs than prior to the Great Recession, and that the number of high wage jobs hasn’t grown at all. These factors mean that the impact of employment on economic consumption is weaker than it was when the Phillips Curve was formulated.

4. Over the past 30 years, globalization has redefined economic realities in the U. S. and around the world. The labor market for both manufacturing and services is no longer local, depending on the industry it can be regional or even global. This has created excess worldwide industrial capacity in numerous sectors.  The powerful deflationary forces of globalization can’t be controlled by the Fed or any other entity.  The Phillips Curve does not even attempt to measure global unemployment or inflation.  And,

5. The digital revolution is making it more difficult to measure inflation because an ever-greater share of the value created by any industry is in the form of non-monetary customer surplus. That means that all of the free goods and services we consume including phone apps, databases, communications networks and entertainment never shows up in the calculations.  In reality, we have experienced 20+ years of “virtual deflation” because we get so much more value bundled into services that have hardly increased in price.   And this trend will only accelerate as the Fifth Techno-Economic Revolution kicks into high-gear.

So where does that leave us?

U3 unemployment keeps falling while inflation remains tame.  The old Phillips Curve assumptions aren’t working for a number of reasons including globalization, technological innovation, industrial restructuring and redefinition of the factors being measured. Yet the Federal Reserve still uses the Phillips Curve logic to pursue its dual mandate.

Given this trend, we offer the following forecasts for your consideration.

First, as globalization slows and political nationalism accelerates, deflationary pressures will diminish and we’ll see a little more inflation.  Globalization has been a strong deflationary force throughout history and especially over the past three decades. But, as discussed previously in Trends, that force is now waning.  This is evidenced by the stagnation in global trade.  In contrast, political nationalism ? historically, a highly inflationary force ? is on the rise.  The slowdown in globalization can be attributed largely to structural factors. For instance, tariff rates fell steadily in the second half of the 20th century, helping to boost global trade in the process.  But now that most goods cross borders duty-free, further efforts at trade liberalization will be subject to diminishing returns. The same goes for outsourcing. In fact, growing evidence suggests that many firms have outsourced too much, leaving them with an unwieldy maze of suppliers around the world; in the coming decade much of this will be unwound.  Likewise, the integration of Eastern Europe and China into the capitalist economy brought a billion additional workers into the global labor force, giving globalization a huge boost. But nothing similar awaits over the horizon.  ? On the other hand, politics increasingly represents a headwind for globalization. Trade among rich countries tends to be less disruptive than trade between rich and poor countries. As emerging markets have become larger players in the global trading system, the impact on less-skilled workers in developed countries has grown.  The result is a nationalist back-lash which will lead to reduced immigration and higher trade barriers, which will raise wages and inflation.

Second, despite the impact of constrained globalization and enhanced nationalism, inflation will not be a significant problem for the U. S. economy for the foreseeable future. With today’s historically low work force participation rate we’re nowhere near “full employment;” though it might become an issue when U6 drops below 5%.  (The pace of Baby Boomer retirement is the main uncertainty.)  Despite the rising “America first” agenda, we still live in a globalized economy with India and Africa waiting in the wings to take over from the aging Chinese and Latin Americans. And most importantly, the productivity boom of the Fifth Techno-Economic Revolution is just beginning to take-off, fueled by the world’s unprecedented capital surplus.  The underlying economics of info-tech and bio-tech mean that the world remains fundamentally deflationary. Given this backdrop, it will be a challenge to generate 2.5-to-3 percent sustained inflation and only sustained real growth of over 4% is likely to create 4% or more annualized inflation.   And,

Third, for policy reasons, the Federal Reserve and other central banks are going to try to lift inflation rates above the current 2% target.  To those who remember the 70s, this seems perverse.  However, looking at the long-term malaise we see in Japan the logic is straightforward: If inflation is 4% and a deep economic downturn requires central bankers to temporarily bring real interest rates down to -3%, this can be achieved by cutting nominal rates to 1%.  In contrast, if inflation is 2%, it may be difficult to cut nominal rates to -1%, since people could choose to hold cash rather than a negative-yielding asset. Furthermore, central bankers learned from the Great Recession that burst asset bubbles can cause significant harm to economies. Here again, a bit more inflation can provide a safety valve of sorts. If the trend rate of inflation had been higher going into the housing bust, nominal home prices would have fallen less for any given change in real prices. This implies that fewer mortgages would have gone underwater. A higher underlying inflation rate would have also made it more difficult for lenders to offer zero-interest mortgages during the boom since their funding costs in real terms would have been greater. This would have imposed more discipline on lenders and borrowers alike. Then there is the labor market. The reluctance of workers to accept nominal wage cuts makes it difficult for real wages to adjust downwards in the face of adverse economic shocks when underlying inflation is very low. If inflation is higher, that problem diminishes. We see this problem today in the euro area, where labor markets are quite inflexible to begin with and many countries do not have the ability to respond to adverse shocks with either countercyclical fiscal policy or currency depreciation.

References
1. Global Investment Strategy, July 28, 2017, Bank Credit Analyst, A New Bottom in Inflation

2. Bloomberg Markets, August 24, 2017, Matthew Boesler, Phillips Curve Doesnt Help Forecast Inflation, Fed Study Finds

https://www.bloomberg.com/news/articles/2017-08-24/phillips-curve-doesn-t-help-forecast-inflation-fed-study-finds

3. Working Paper No. 17-26, Federal Reserve Bank of Philadelphia, August, 2017, Michael Dotsey, Shiguru Fujita, & Tom Stark, DO PHILLIPS CURVES CONDITIONALLY HELP TO FORECAST INFLATION?

https://www.philadelphiafed.org/-/media/research-and-data/publications/working-papers/2017/wp17-26.pdf

4. First Trust Portfolios, September 25, 2017, Brian S. Wesbury& Robert Stein, Low Inflation is No Mystery

http://carlsonwm.com/low-inflation-no-mystery/

5. Forbes, September 6, 2017, Robert Barone, Fed And Phillips Curve Point To Lingering Deflation And Low Interest Rates

https://www.forbes.com/sites/greatspeculations/2017/09/06/fed-and-phillips-curve-point-to-lingering-deflation-and-low-interest-rates/#51fc2ebe2c9c

6. MISH TALK, August 10, 2017, Mish Shedlock, Oh that “Elusive Inflation!

https://www.themaven.net/mishtalk/economics/oh-that-elusive-inflation-EmV6IXLtbk6TTOV5fYp9cQ