The Rise and Fall(?) of the Phillips Curve
2023 10 20
Rogé Karma has a backgrounder on the history of the Phillips Curve. He does not use the term, but the idea was that there is a trade-off between unemployment (of labor) and inflation: low unemployment/high inflation and vice versa. This sets up a dilemma for the Fed which is supposed, by Congressional mandate, to seek stable prices and maximum employment. The locus classicus of the idea was [Here beginneth the potted history.] the period of stagflation in the’70’s terminating with high inflation that was broken only when Paul Volker had the “courage” to impose high interest rates, resulting a sharp recession and unemployment but with inflation reduced.
There was a reason to think there could be a trade-off between unemployment and inflation in the 1970’s. Was it the real reason? I don’t know, but the theory made sense. The idea was (simplifying as any model has to) that the macroeconomy consisted of one output – GDPStuff – produced with one input, Labor. As with any simple supply and demand analysis there is a price of Labor at which it was fully employed and GDP was maximized. In this scheme if we suppose that wages, the price of labor, was arbitrarily set higher than the equilibrium price (“union power!!!!”) the amount of labor demanded and the amount of GDPStuff produced would fall – recession and unemployment. A partial explanation for how this could happen is that firms would agree to higher wages because they expected to be able to raise their own prices and if the Fed validated this with expansive enough monetary policy, this would turn out to be a correct expectation across the whole economy. In effect the Fed would be inflating the price of GDPStuff so that the real, inflation-adjusted wage was reduced and unemployment and recession reversed or avoided.
Play this sequence out several times and the observed result would be the Phillips Curve tradeoff.
It’s important to note that without inflationary expectations this would not play out; there would be one spurt of inflation and full employment would be restored. Expectations (and an always accommodating Fed), however, will produce a “wage-price spiral.” But the idea was that if one knew how expectations were formed, the trade-off between inflation and unemployment would be stable and the Fed could at least choose the least bad combination of unemployment and inflation, what Arthur Okum of the University of Michigan economics department where I was in graduate school termed the “misery index.” [Oh, unhappy memories of 1967 trying to estimate a distributed lag inflation expectation equation when we had to solve regression equations on a mechanical calculator! (We did have piped water and indoor toilets, however. 😊)]
With inflation “tamed” and inflation expectations (and “union power?”) “broken” or “anchored” by a credible Fed inflation target, the macro economy was set for les trente glorieuses of low inflation. One could still think that a Philips Curve existed, just that we were on low inflation points along the curve. The Great Recession with a decade of persistent under-target inflation and glacially slowly falling unemployment was not inconsistent with the idea of a stable Phillip Curve.
Hence as Karma recounts, last year there was a “‘traditionalist view’ of monetary policy: the belief that the only way to tame inflation is by causing a recession. This view so thoroughly dominates the economics profession that it is often considered something closer to a law of nature. It is why, when inflation began taking off last year, nearly every economist, forecaster, and CEO believed a recession was around the corner.” [Last October Bloomberg reported a “consensus” of economists was the probability of a recession in 2023 was 100%.] The counter belief – the consensus was never 100% -- that a “soft landing” was possible was mocked with the phrase “immaculate deflation.”
So here we are in late 2023 with inflation having come down sharply with no recession, no unemployment. Is the Philips Curve pasé or one of Krugman’s “zombie ideas.” I think so and the reason is that the economy is a lot more complicated than GDPStuff produced by undifferentiated Labor. And it is complicated in a significantly different way. Wages are not the only relative price than could get out of equilibrium and in point of fact were NOT the point through which supply chain and the Putin oil shocks impacted the economy in 2021, shocks that the Fed very properly allowed inflation to facilitate a readjustment of relative prices when some prices move down with difficulty if at all. In this view, there is no one Phillips Curve in labor unemployment and inflation but a myriad of “Phillips Curves” in diverse markets.
This does not however make the Fed’s job easy. It does imply the possibility of reducing the inflation — inflation that the Fed itself allowed in order to facilitate adjustment to non-labor market shocks — without producing unemployment of labor. It does not guarantee that it will be able to do so. As the Fed tries to squeeze inflation from the system, it could go too far, reduce inflation too much, produce unemployment and a recession and voila; the Phillips Curve would be reborn.
First of all real wages did not rise during the 1970's. Over the March 1975 to Jan 1980 expansion, unemployment averaged 6.9% with a minimum of 5.6%. This is a recession level of unemployment. Real wages did not rise because high unemployment meant a labor surplus. When supply is greater than demand, the price (wage) falls, which is what happened. In such a world union power evaporates. Union power,, measured by strike frequency, fell dramatically after 1978, never to recover.
The idea of wage-push inflation that circulated then was a bullshit meme, maybe even propaganda. It worked; I believed it then and was anti-union for a time as a result. It seems to me that the Phillips curve mechanism works in a simple fashion. If you throw people out of work, their spending goes down and so does that of folks worried about losing their jobs. This means less demand for stuff, and if demand falls faster than supply you would expect price inflation to fall.
Finally, federal fund rates were at 10.2% when the unemployment minimum of 5.6% was reached, and would exceed 13% five months later and 17% five months after that. How is this accommodative?
The cause of 1970's stagflation is simple. Prior to the "October Revolution" in economic policy, the Fed had partnered with the federal government in managing the economy. The government abdicated this responsibility over 1962 through 1971, and finally with the appointment of Volcker and a conservative administration determined to destroy the labor movement, by maintain high unemployment long enough to produce a new generation of workers that accepted the reality that their incomes would not keep up with rising living standards. As it turned out a new deflationary force had emerged in the 1990's that pretty much eliminated risk of major inflation unless government deficits got really out of hand. And that is where we were until 2021. And now it's a new world all over again.
The government is even more useless than it was in the 1970's and the Fed is trying, but they are only human.
Nice post.
Your story reminds me of something Robert Solow often pointed out - maybe he still does: that the Phillips Curve was originally observed as a relationship between unemployment and **wage** inflation (not the change in the overall price level). This creates exactly the possibility that you mention - that there could be many Phillips curves, one for each relative price, and therefore a lot of noise and information loss in generalizing these relationships (many of which might be zero correlation) into one between unemployment and a non-relative, aggregate-price-change headline number.
Contrast the humility that would result from such an awareness with the pose struck by our situation-room-dominating friend, Larry Summers, who can to all appearances sail these monetary policy seas with scarcely any reference to a model , and with no need for any kind of compass other than constantly repeating the phrase "history tells us..." It's an impressive performance - and a frightening one. It's as if Larry died and came back as his own private Phillips Curve. All he seems to care about is what unemployment rate was "required" over the last 50 or so years to reverse an episode of inflation. And he keeps insisting that inflation isn't **really** reversed until such and such an unemployment number is attained.