To link inflation and unemployment, you don´t need the Phillips Curve

Recently Joe Gagnon of the PIIE (Peterson Institute for International Economics) has used both the US and Japan to argue that there is no inflation puzzle. In other words, the Phillips Curve is alive and well.

In the US piece, Gagnon writes:

Some economists are puzzled over why US inflation has remained low while the economy has reached, or even exceeded, potential employment. Commentators have argued that central banks are wrong to place too much faith in the Phillips curve model, in which inflation responds to deviations from potential employment…,

Yet inflation is behaving exactly as the Phillips curve would predict. The decline in the US unemployment rate is too recent and too small to have caused any significant rise in inflation to date. Inflation is likely to pick up a bit next year, which supports the Fed’s tightening path, albeit with a considerable degree of uncertainty.

The true puzzle from the point of view of a simple Phillips curve model is the lack of much downward movement in inflation in 2010–14, when the economy was far below potential employment. But this puzzle is easily explained by the fact that workers and firms strongly resist outright declines in wages and prices.

After some “gymnastics”, for example, devising high and low inflation environments, Gagnon concludes:

Based on the Phillips curve, we would expect inflation to rise by about half a percentage point over the next year. But historical experience suggests that inflation may end up anywhere from 1 percentage point lower to 3 percentage points higher.

In other words, the Phillips curve remains an important fundamental driver of inflation, but we should not overstate the precision with which it operates.

“Solving” the inflation puzzle within the confines of the Phillips Curve, ends up being “incredible”. The assumption of sticky wages is fine since it is an empirical fact. The problem resides with the unobservables, things like “natural rate of unemployment or potential output”.

Why should unemployment, a real variable, be fundamental in the determination of inflation? The story posits that a “tight” labor market (“low” unemployment) puts pressure on wages, which will end up lifting prices. It is another example of what used to be called “cost-push” inflation.

If you subscribe to the view that inflation is a monetary phenomenon, you should look at monetary policy, the stance of which is given by the growth of NGDP relative to trend, not by interest rates.

The chart contemplating the period of low and stable inflation of the past 24 years helps to illustrate.

The relatively stable NGDP growth trend up to 2007 goes hand in hand with a low and stable trend rate of inflation. When there´s a monumental monetary shock that turns NGDP growth negative, inflation notches down. While it averaged 1.9% before 2007, it only averages 1.6% since 2010.

Given the strength of the monetary shock, why didn´t inflation fall by more? Here, Fed credibility and anchored inflation expectations explain the “surprising” outcome. As to inflation getting “too low”, just remember Bernanke´s 2002 speech “Deflation making sure “it” doesn´t happen here”.

With NGDP growth again stable after the crisis, albeit at a lower trend, there is simply no way for inflation to climb higher.

What about the unemployment rate? In the chart, you also see that monetary policy is an important determinant of the cyclical fluctuation in unemployment.

The red arrows indicate that when NGDP growth falls significantly below trend or, as is the case in 2008-09, it tanks, unemployment goes up, or, as in 2008-09, it shoots up. The mechanism works through wage stickiness. Given wage stickiness, when NGDP growth falls, the wage/NGDP ratio goes up (or shoots up), and so does the unemployment rate.

With NGDP growing, even if at a lower rate than prior to the crisis, but growing at a rate higher than the rate of wage or compensation growth, the wage/NGDP ratio falls and so does the rate of unemployment.

The blue arrows indicate those times when NGDP growth took a “breather”. Note that during those periods the fall in unemployment slows down.

Bottom line: What links inflation and unemployment is monetary policy, the stance of which is given by NGDP growth relative to trend. The behavior of inflation is made “resilient” by central bank credibility and anchored inflation expectations. In those circumstances, the rate of unemployment is cyclically much more sensitive to monetary policy, at the same time showing little or no relation to inflation.

With the Fed´s “tightening resolve” intact, the “talk of the town” is yield curve flattening and future inversion. If the Fed goes on as expected, yield curve inversion will happen. The Fed, however, has a standard answer: “This time it´s different”!


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