Tuesday, May 15, 2018

Lesson 22 The Phillips Curve

Below is something called the Phillips Curve. I thought it had expired but I read an article in the Wall Street Journal last week and realized it is back to haunt us. So I am on a mission today.

Like the Laffer Curve, the Phillips Curve is one of those graphical devices named after an economist that is misunderstood and totally abused. Like a good training bra, these curves have their time and place but can easily be misapplied.

I'll save Art Laffer and his curve for another time. A.W. H. Phillips studied wage change and unemployment in the UK from 1861 to 1957. I am not sure why his parents gave him so many initials and that deserves a lot of study, but I won't go into that today either. To make a very long story short, we Americans who wanted to be great again in the 1950s decided to steal Mr. Phillips' curve and apply it to our study of inflation and unemployment in the US.

The result of this study is to think that there might be a stable relationship between inflation and unemployment. Thus we draw the curve with a negative slope and pretend that it sits there until hell freezes over.  For you friends who are not mathematicians, this means that any reductions in the unemployment rate should cause the inflation rate to increase. Or, in other words, when the economy grows rapidly enough to reduce the unemployment rate this puts pressure on markets. Tight labor markets mean that wages rise faster. Tight goods markets mean that prices rise faster. That doesn't sound so crazy, does it?

In our current context in the US, we recently saw the unemployment rate decline to 3.9%. Applying the Phillips Curve means that inflation should be rising. Applying the Phillips Curve to the future means that if the unemployment rate remains low or heads lower -- then surely inflation will rise even more. Again, that doesn't sound so crazy. Of course, we wonder why inflation has not already soared given the tremendous declines in the unemployment rate.

The confusion is that economists are used to models that focus on supply and demand. And while discussions of the Phillips Curve often involve throwing around those words, the Phillips Curve is neither a supply curve nor a demand curve and this drives us crazy. What is it? Basically, it is a useful construct that amalgamates supply and demand but in ways that satisfy only the user. One user says one thing; another user says another.

This lack of consensus arises because we are using this construct as a proxy for an inflation forecasting equation. An inflation forecasting equation stems from a model. This explicit model has two components -- the aggregate demand for goods and services (AD) and the aggregate supply of goods and services (AS). To understand changes in the inflation rate, you must examine all the major things that impact a country's AD and AS. One of those things is the unemployment rate.

Did I underline the word one? I should have. Only one of the zillions of important things that impact inflation is the unemployment rate. Don't get me started because a zillion is a lot of things to discuss. But consider some of the important ones. Oil prices are starting to rise again these days. Might that impact inflation in the USA? What about when prices of mobile phone services fell? Would that impact the national price level? Declining productivity? Global competition? Agricultural surpluses?

Some economists understand that when any of these other inflation-causing factors change, then the whole Phillips Curve shifts. Things that cause inflation to rise cause an upward (leftward) shift. Things that cause inflation to fall cause a downward (rightward) shift. The Phillips Curve is not an immutable object nailed to the floor. It bounces around like Nolan in a bounce house. Thus, pretending that the Phillips Curve just sits around all the time is bound to lead to errors in one's inflation forecast.

Notice what we are saying these days. As the unemployment rate falls we are pulling our hair out about rising inflation. We are sure that the Fed will, then, more aggressively fight inflation. And because the Fed will react like Pavlov's pup, many are already forecasting a recession. While all that might be true, it ignores a lot of other things going on that might preclude the inflation rate from rising. Maybe the global economy is slowing down? Maybe we have plenty of workers ready to jump into the labor market or at least switch their status from part-time or from underemployment. Maybe tax reform will improve productivity and facilitate more competitive pricing. Maybe continued innovations and competition in IT products will reduce prices we pay for all sorts of products. Maybe Alexa will wash your car for free.

The Phillips Curve is a pedagogical device. It doesn't sit still for anyone. Focusing on the impact of unemployment on inflation is like trying to forecast how your kid will behave after eating a cookie. While the cookie might  have one impact, myriad environmental and emotional factors should not be ignored. Give the kid the cookie!


  1. Dear LSD. You make a good point, but I think the Fed ought get the box of cookies.

    1. The Fed is beyond hope. I'd give them a lump of coal instead.

  2. Who said you cant get a free education? Thanks Larry