The Phillips Curve Rides Again

Just when you think the Phillips Curve vanished, it reappears. For those of you who have managed to steer clear of the concept known as the Phillips Curve until now, I would suggest pouring a nice JD over some rocks and watching the grass grow. For those of you who might be even a little curious about this Phillips Curve thing, then read on.

Phillips was one of those New Zealand economists with a lot of initials (A.B.H. aka A.W.H., aka Bill, aka William) before his last name who got famous by noting that there appeared to be a relationship between Ozzie and Harriett – no just kidding – between Ricky and Lucy – just kidding again – between the unemployment rate and wage changes.

This seems innocuous enough, but then real American economists decided to make Phillips even more famous by making the Phillips Curve the truly greatest thing ever in macroeconomics and skateboarding. The first thing they did was replace the wage variable with prices. Thus, they pondered a relationship between the unemployment rate and inflation (the percentage change in prices). I don’t think they got permission from Phillips to make this change but that’s all history now. 

Next they gave the relationship a theoretical foundation. Fancy words – theoretical foundation. The truth is that a monkey with the latest iPhone could have dug up this theory. But sometimes simple things catch on. And they catch on when they support the latest trend in macroeconomics. Recognizing that I am a bit north of my 70^th birthday, please understand that when I talk about the latest trends, I am usually referring to the 1960s.

Unlike pink poodle skirts and flat-tops, macroeconomic trends stay around a while. My point today is that the Phillips Curve comes and goes in popularity, but as I was reading the Bible – err I mean the Wall Street Journal – this week it occurred to me that the Phillips Curve had risen from the dead again.

Before I get into those juicy headlines, let’s at least review the basics of the Phillips Curve. Below is a Phillips Curve diagram. The most popular aspect of it is the negative slope that reveals the inverse relationship between inflation and unemployment. Or in more common language, when one of them goes up the other one of them goes down. Sort of like a seesaw.

One might ponder further and say something like, “why?” Why is there a seesaw relationship? The answer comes from short-run macroeconomics and the part of it we call aggregate demand (AD). When households or firms or movie actors decide to buy more stuff, firms get very happy and respond by producing and selling more stuff. To produce more stuff they need more workers and so the unemployment rate goes down. As they hunt for more workers, they raise wages and then they must pass some or all of that wage increase on to their prices. 

Thus when AD increases – unemployment goes down and inflation goes up. Or when AD decreases – unemployment goes up and inflation goes down. Are you seasick from the seesaw yet? That’s basically it. Stay awake Fuzzy.

The big deal is that this little bit of theory is what is behind our love of using monetary and fiscal policy to rev up spending in a flagging economy. Monetary and fiscal policies are designed to pump up AD and therefore save the world from high unemployment – though at a cost of higher inflation.

To get these results, the Phillips Curve is not allowed to move around. It must sit still. Stay Phillips Curve. Stay. Good Phillips Curve. When the Phillips Curve does start to mosey around on the diagram, it messes up the nice seesaw and it ruins the simple world of monetary and fiscal policy. So when the Phillips Curve is jumping to and fro, we forget it exists. But when it sits nicely we take it for a walk.

The last 10 years or so, most economists would rather talk about soccer than Phillips Curves. The unemployment rates around the world went down – but the inflation rate just sat there like a squirrel on Zoloft. That is a sad story for the Phillips Curve. Bad Phillips Curve. 

But all that is changing now. Take Turkey for example. I was going to use Ham instead but we are actually talking about the country, Turkey. The central bank of Turkey recently decided to raise interest rates. And the government got steamed. Why was the government so mad? Because they believe that the rise in interest rates will reduce borrowing for spending and that will cause firms to produce less and fire a lot of workers. Of course, the country would benefit by a slide down the Phillips Curve to lower inflation rates. But the possibility of the higher unemployment rate was too much to risk. Clearly the government of Turkey believes in the Phillips Curve.

Japan is another example of the reincarnation of Phillips. Japan has been bathing in zero or negative inflation for decades. It now seems that inflation is making a comeback – a humble comeback but a comeback nevertheless. So should they be concerned with rising inflation and pull back on stimulus? And risk a rise in the unemployment rate? It's all about Phillips. A decision to curtail inflation will cause higher unemployment if you believe in the stationary seesaw.

It goes without saying that the same discussion is happening in the USA. The Fed has been moving interest rates upward for more than a year now and they plan to keep raising them in 2018 and 2019. A return to normal interest rates, like a return to normal temperatures after sitting in a beer refrigerator for hours, makes sense. But that bit of logic is trampled by the Phillips Curve. The curve was missing in action for 10 years but now all of a sudden it is more popular than a soju in Insadong. Surely if the Fed raises rates a couple more notches, the unemployment rate will rise. Surely if the Fed worries about inflation rising, unemployment will rise.

Okay. Enough about Phillips Curves. Next week I discuss the Davidson Curve. Just kidding again. Who moved my JD?