Opinion – Why? Economês in plain English: Where does the Phillips curve go?

The Phillips curve represents the inverse relationship between, on the one hand, inflation rates and, on the other hand, levels of the unemployment rate and/or the degree to which a country’s potential GDP is actually being produced. Inflationary pressures increase as unemployment declines and/or the heating up of economic activity begins to conflict with its capacity, and vice versa. It is named after the British economist AW Phillips, whose 1958 article examined unemployment and wage growth in the UK between 1861 and 1957.

Its relevance for macroeconomic analysis and monetary policy decisions is immediate, as interest rates depend on the level of aggregate demand and, therefore, on the extent to which potential GDP will be (under or over) utilized. Therefore, the Phillips curve expresses the “inflation-unemployment dilemma”.

In principle, at each moment in time there would be a level or range of interest rates at which demand pressures would not be excessive or insufficient in relation to potential GDP, not by chance called the “neutral” rate of interest, since inflation levels and unemployment would tend to remain stable. Consistently follows the idea that there is a certain rate of unemployment that inflation does not accelerate.

Well then! The relationship between unemployment and inflation expressed in the Phillips curve does not necessarily remain stable, fixed. In addition to possible supply-side shocks altering the relationship, there are also endogenous changes when the economy spends some time operating far above — or below — the neutral level.

In situations of overheating and rising inflation, the expectations of economic agents regarding this can lead them to reaction behaviors that end up establishing vicious circles of inflationary feedback. What’s more, once that happens, expectations and behavioral feedback will only be reversed with the economy going some period below its potential, during which the inertia of inflation will still keep it going for some time.

This is the essence of the so-called “stagflation”—significant inflation, high unemployment, and zero or low economic growth—observed in the 1970s and 1980s in the United States. The Phillips curve had shifted upwards and inflation only declined after a period of higher unemployment.

The following decades saw the period of “great moderation”, the name given to the period of low macroeconomic volatility experienced in the United States from the mid-1980s until the 2007-08 financial crisis. The Phillips curve had turned down.

And the shift seemed confirmed after the “great recession” that followed the financial crisis. The US economy took a while to recover, but ended up going through a long and stable expansion for more than 10 years, at rates below historical averages, but corresponding to a record of time without recessions. Unemployment remained low, with a rate lower than at low points in the previous 50 years, reaching 3.5%.

Meanwhile, inflation remained below the Federal Reserve’s 2% target, averaging 1.7% throughout the expansion. The looseness of monetary policy — including “quantitative easing” by the Fed buying government bonds and mortgages — has not tickled inflation.

Two were the most cited factors to explain this “flattening” of the Phillips curve. One was the anchoring of inflation expectations at low levels. Another is the possibility opened up by the globalized economy that, instead of upward pressures on domestic prices of products that may be in short supply, imports could act as absorbers of demand. In the absence of generalized overheating, globalization would be functioning as a buffer for inflation in individual countries.

Then came the rise in inflation with the supply shocks accompanying the pandemic, the invasion of Ukraine and the “perfect storm”. From “temporary”, accelerated inflation became recognized as something not automatically reversible.

Not least because it also reflected the size of fiscal and monetary stimulus in advanced economies, with the sharp channeling of demand for goods —in replacement of services— creating bottlenecks in supply chains and conflicting with supply capacities. On top of that, the workforce has contracted, reducing possible employment levels.

The Phillips curve shifted. As Gita Gopinath, the IMF’s first deputy managing director, presented at the Jackson Hole meeting last month, less than a quarter of a percentage point of the rise in inflation would be attributable to unemployment falling below the “natural” rate estimate, or that is, the one to which inflation would not tend to accelerate. In any case, there is now an international synchrony in the option of tightening monetary and fiscal policies, making even a global recession likely ahead.

And now? Where does the Phillips curve go? Can you imagine the relationship returning to how it was before the pandemic?

According to a report last week by the Institute of International Finance (IIF), the effect of the pandemic as a source of shocks on supply chains seems to have ended, with a view to normalizing delivery times and reducing its upward pressure. about inflation. On the supply side, however, there are still the impacts of the war in Ukraine on global inflation, especially in Europe.

Furthermore, the post-pandemic job supply will remain difficult to predict for some time. There is also the risk that “relative deglobalization” measures on value chains will undermine the mechanism of balancing supply and demand via foreign trade, rather than domestic prices.

And on the aggregate demand side? Will the low long-term interest rates that prevailed in the recent past return or has the “perfect storm” brought structural changes?

Gita Gopinath suggests that while demographics, income inequality and a preference for safe assets will continue to keep them low, rising debt during the pandemic and inflationary shocks accompanying the energy transition will play in the opposite direction. In turn, it is difficult to predict where labor supply and productivity will go.

The Philips curve will keep moving. Meanwhile, it is also necessary to verify whether the monetary adjustment programs underway will effectively hold inflationary targets as anchors for expectations.