Has the Phillips Curve finally been buried?
Whilst the FT reports on the Fed’s new strategy as just another incremental codification of its extremely dovish policy, Reuters reads it as a final straw flattening the curve out of existence:
“One of the fundamental theories of modern economics may have finally been put to rest.” Read whole article here or below
For background and context please read my previous post on Inflation and the much misunderstood Phillips Curve.
Otherwise just follow the money…
updates 8/2021
voxeu.org 20/8/2021 The euro area Phillips curve: Damaged but not dead Elena Bobeica, Benny Hartwig, Christiane Nickel
….”…While a formal quantitative assessment of the slope/shape of the Phillips curve during the pandemic is hindered by a myriad of technical and economic factors, there is evidence pointing towards the conclusion that the Phillips curve-type mechanism is still at play. Underlying inflationary pressures in the euro area have been dampened by the build-up of economic slack. After an initial stickiness, HICP inflation excluding energy and food reached 0.2% at end-2020, suggesting that the link with the amount of slack is playing a role. Also, while at the beginning of the pandemic the constellation of shocks blurred Phillips curve relations (supply shocks dominated), the normalisation phase is characterised by demand shocks kicking in and re-establishing the positive relation between prices and real activity. Supportive evidence for the link between prices and demand is provided also by micro data. Web-scraped supermarket data from PriceStats for the big-five euro area countries revealed that the textbook relation between prices and demand is not dead. The number of products available online started to decrease at the beginning of March 2020 and, at the same time, the share of products offered at a discount was nearly 40% lower in mid-April 2020 than a year earlier (Henkel et al. Rodari 2021). On the wage inflation side, where the data distortions are even more pronounced, there is some indication that the higher slack in the labour market might play a role. Wage negotiations during the pandemic have been delayed or, for a few countries where such negotiations have been concluded, the outcome points to lower wage increases (in some cases, no increases).
To conclude, the pandemic made it even more obvious that “finding the Phillips curve is like finding a needle in a haystack. But it is hidden there somewhere!” (Reichlin 2018).”
https://voxeu.org 2020 A Phillips curve for the euro area Laurence Ball, Sandeep Mazumder
link.springer.com 2019 The Phillips Curve by James Forder
Friedman’s observations on the Phillips curve are considered. Consonant with Macroeconomics and the Phillips curve myth, it is argued that the idea that policymakers ever believed excess demand could bring low unemployment at the expense of only stable inflation is a fiction, and that in any case, Friedman made no original arguments on the point. Close analysis of what Friedman said about the Phillips curve, and when he said it bears out that view, and shows that Friedman adopted a fictitious historical story in 1975 and thereafter gave inappropriate emphasis to his own supposed innovation in the matter.
voxeu.org 2019 The Phillips curve: Dead or alive Peter Hooper, Frederic S. Mishkin, Amir Sufi
The apparent flattening of the Phillips curve has led some to claim that it is dead. The column uses data from US states and metropolitan areas to suggest a steeper slope, with non-linearities in tight labour markets. We have been here before – in the 1960s, similar low and stable inflation expectations led to the great inflation of the 1970s.
voxeu.org 26/2/2021 Friedman vs Phillips: A historic divide Manoj Pradhan, Charles Goodhart
Milton Friedman and Bill Phillips most likely assumed that their separate methods for predicting inflation would lead to much the same outcomes. Recently, however, monetary aggregates and the Phillips curve have provided extremely disparate signals. This column discusses recent economic developments leading to these disparate signals, concluding that inflation will most likely end up somewhere between the predictions of the two models – which is almost certainly higher than what central banks and the IMF are expecting.
Abstract
The notion of the Phillips curve as a policy tool was first advanced in 1960 by Paul Samuelson
and Robert Solow. Despite their pointing out features of the curve that would later become
prominent, (i.e., that the curve could shift), it helped create the environment that allowed
inflation in the United States to accelerate during the 1960s. Ironically, Samuelson and Solow
never estimated their Phillips curve, but instead hand drew it to fit the data for the twenty-five
year period from 1934 to 1958. Using the data and econometric techniques available to them at
the time, we estimate the Samuelson-Solow Phillips curve, find that it bears little resemblance
to their hand-drawn curve, and discuss the policy implications of the two curves.
“Some international evidence for Keynesian economics without the Phillips curve”
Roger Farmer, Giovanni Nicolò 20 May 2019
In our view, there has been no stable Phillips curve in the data of any country since Phillips wrote his eponymous article in 1958. In Farmer and Nicolò (2019), we show how to replace the Phillips curve with the belief function, an alternative theory of the connection between unemployment and inflation that better explains the facts. That theory is explained in more depth in Farmer (2016) and in a recent research paper (Farmer and Platonov 2019). The research programme we are engaged in should be of interest to policymakers in central banks and treasuries throughout the world who are increasingly realising that the Phillips curve is broken.
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Reuters article copy
With new monetary policy approach, Fed lays Phillips curve to rest
In the several years before the coronavirus pandemic took hold of the global economy, Federal Reserve policymakers watched as the U.S. unemployment rate fell lower and lower and waited for the jump in inflation typically associated with such a tight labor market.
The expectations were based on a rule that has shaped decades of monetary policy decisions: the Phillips curve, or the concept that inflation tends to rise when the unemployment rate falls, and vice versa.
But the inflation that Fed officials anticipated never arrived, and in a monumental speech delivered on Thursday, Fed Chair Jerome Powell announced that the U.S. central bank’s policymakers are done waiting.
The Fed chief, speaking during the Kansas City Fed’s annual conference, unveiled the central bank’s new approach to monetary policy, which puts more emphasis on shortfalls in employment, and less weight on the fear that low unemployment could spark higher inflation.
“The conditions in the economy have changed to such an extent that this upwardly sloped relationship between inflation and employment has now changed,” said Joseph Brusuelas, chief economist for RSM. “Decades of thought at the Fed are now being pushed aside.”
With its landmark policy shift, the Fed is putting new weight on bolstering the labor market and less on inflation, promising to aim for 2% inflation on average over a period of time rather than using that figure as a hard annual target, as it had done since 2012.
With their new approach, Fed officials are essentially saying they are no longer worried about the unemployment rate falling too low. Now that inflation expectations are anchored at low levels, the economy has room to keep adding jobs.
Policymakers can also wait a little longer for the gains to reach the workers on the margins – including Black, Hispanic and low-income workers – who are often the last to reap the benefits of a tight labor market, Powell said.
“It is hard to overstate the benefits of sustaining a strong labor market, a key national goal that will require a range of policies in addition to supportive monetary policy,” Powell said on Thursday, reflecting on the strong U.S. labor market that existed before the pandemic.
More Flexibility
The relationship between inflation and employment was documented by A.W. Phillips, an economist from New Zealand who published a paper on the topic using British data on unemployment and wages from 1861 to 1957.
The concept became a key aspect of the Fed’s decisions on interest rates, motivating officials to start raising borrowing costs when they feared that inflation could soon take off.
But policymakers and economists have noticed that the relationship between inflation and employment has weakened over the past several years.
For example, between 1960 and 1985, a one-percentage-point drop in the gap between the unemployment rate and what economists viewed to be the long-run level of unemployment, would lead inflation to grow by 0.18 percentage point as measured by Personal Consumption Expenditures, according to a 2018 analysis by the Washington-based Brookings Institution.
From 1986 to 2007, that effect was reduced to less than half of its previous impact and it “essentially disappeared” after 2008, the analysts wrote here
That shift, known as the flattening of the Phillips curve, made the tool less useful for predicting inflation and making monetary policy decisions, said Karim Basta, chief economist for III Capital Management. “The main thing is that the Fed is not going to be preemptive in raising interest rates,” Basta said. “It’s going to be more reactive to actual inflation.”
That shift gives the Fed more flexibility to make sure that all kinds of workers are benefiting from the economy before it begins to raise rates, Brusuelas said, nodding to the change in the Fed’s statement saying that maximum employment should be “broad-based and inclusive.”
“It’s a good thing for the economy,” he said. “It means we’re going to have more people employed once we emerge from the current crisis.”
