The low inflation seen in industrialized nations calls into question established economic models. Do instruments such as the Phillips curve still work?
Curves are omnipresent in macroeconomics. They are a visualization of generally accepted economic relationships and trends. The Laffer curve, for example, is a cornerstone of supply-side economic theory and illustrates that government revenues can be increased through tax cuts. The Kuznets curve shows the relationship between inequality and economic development, and the Beveridge curve shows the relationship between unemployment and the job vacancy rate. The most important curve, however, is probably the Phillips curve.
The Phillips curve is based on an article by Alban W. Phillips written in 1958 and illustrates the relationship between the unemployment rate and wage increases. It shows that the higher the unemployment rate, the lower the wage increases in an economy – and vice versa. According to the model, this is due to the decreasing bargaining power of employees and the dwindling pressure on employers to pay higher wages.
Because companies usually compensate for the cost of a wage increase by raising prices, a modified Phillips curve was later developed that shows the relationship between the unemployment rate and consumer prices. It is based on the premise that unemployment can be counteracted with higher inflation.
For the world’s central banks, the Phillips curve is an important monetary policy instrument. The US Federal Reserve is striving to achieve price stability paired with a high level of sustainable employment. Although the European Central Bank’s mandate is limited to price stability, it also uses the Phillips curve for its monetary policy strategy. Central bankers therefore take the relationship between inflation and unemployment into very careful consideration.
In recent years, however, they have been rubbing their eyes in disbelief: although major economies have been growing for years and full employment prevails, inflation is increasing only slowly. This raises the question of whether the Phillips curve is still valid. The American star economist Nouriel Roubini speaks of the mystery of missing inflation and Princeton professor Alan Binder has gone as far as to talk of the death of the Phillips curve.
Such criticism is not a new phenomenon, however. A look at the past shows a certain instability of the Phillips curve. For example, in the 1970s and early 1980s, the United States experienced stagflation, or in other words, high inflation paired with high unemployment. During that period, Ronald Reagan attempted to fight rising inflation with high interest rates and led the economy into a recession.
According to the Phillips curve, the inflation rates in industrialized nations should be significantly higher at present. The reason for the surprising lack of inflation is attributed to numerous factors – in industrialized countries, unions have lost some of their influence, digitalization allows for a rationalization of jobs and globalization is putting pressure on wage increases. If one believes these arguments, then wage growth should be expected to remain weak in the coming years, despite low unemployment.
A look at the most recent developments in the US paints a different picture, however. Since 2015, US inflation has risen consistently in a good labor market environment and has generally been above 2% since 2017. The only short-term correction came as a result of the COVID-19-related rapid rise in US unemployment. The link between price stability and employment therefore does in fact appear to exist and the lack of inflation would seem to be a cyclical rather than a structural phenomenon. This is highlighted in the following chart:
If one looks at the relationship between US unemployment and US inflation over the years, it can be seen that the Phillips curve theory proved correct nine times out of ten when unemployment fell below 6%. With the exception of the Asian crisis in 1997 (see red band), there was a strong rise in inflation during these periods. During the most recent period, prices have also risen once the 6% unemployment rate has been reached. It would therefore appear that the Phillips curve continues to be valid.
In theory, there is no difference between theory and practice, but in practice, there is.
Yogi Berra, baseball player.
As indicated at the outset of this article, economic curves are only a visualization of accepted economic relationships – no more and no less. They are abstract models that do not always give consideration to the complex realities. Due to the constant changes in economic relationships, economics cannot always be exact. And divergences between theory and practice will continue to exist in the future. Perhaps we should reflect on the words of former baseball player Yogi Berra, who once said: "In theory, there is no difference between theory and practice, but in practice, there is.
If we are mindful of its weaknesses, the Phillips curve can continue to serve as a useful instrument for forecasting inflation in the future.
This article has originally been published on the LGT finance blog (German only).
Andreas Vetsch is Research Analyst at LGT Capital Partners. The asset management specialists of the company search worldwide for attractive investment opportunities and the best portfolio managers. They also manage a substantial share of the wealth belonging to LGT’s owner, the Princely House of Liechtenstein.
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