The Unassuming Economist

From the Federal Reserve Bank of San Francisco:

“A hot economy eventually boosts inflation. Such is the simple wisdom of the Phillips curve. Yet inflation across developed countries has been remarkably weak since the 2008 global financial crisis, even though unemployment rates are near historical lows. What is behind this recent disconnect between inflation and unemployment? Contrasting the experiences of developed and developing economies before and after the financial crisis shows that broader factors than monetary policy are at play. Inflation has declined globally, and this trend preceded the financial crisis.

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The world economies have mostly recovered from the 2008 financial crisis. In the United States, United Kingdom, and Germany, for example, the unemployment rate is now below 4%, lower than it has been in decades. Tight labor markets are usually a symptom of a healthy economy and thus a rising demand for goods and services. To satisfy such demand, businesses usually raise prices—the basic mechanism underlying the standard economic relationship known as the Phillips curve. Yet, 10 years after the financial crisis, inflation has held remarkably steady. Some researchers therefore argue that the Phillips curve is no longer a useful descriptor of inflation dynamics (Coibion and Gorodnichenko 2015).

In this Economic Letter, we investigate whether the financial crisis has changed the long-standing inner workings of the Phillips curve. We extend the analysis in our previous Economic Letter (Jordà et al. 2019) to include developing economies and analyze three components of the Phillips curve to assess where the links appear to be broken.

Our analysis suggests that news of the death of the Phillips curve in developed economies appears premature. Fluctuations in labor market conditions have been largely offset with appropriate interest rate changes by central banks. Under such conditions, the influence of past inflation has faded, and expectations for future inflation have gravitated toward the central bank’s stated target. On the surface, inflation appears stable at all levels of labor market slack, and the Phillips curve link appears broken. Underneath, however, the Phillips curve could still be at work. The inflation dynamics that we observe could also be explained by a central bank that successfully offsets fluctuations in slack to keep inflation at the target. In less developed economies, central banks often operate under constraints that prevent full monetary policy offsets, which has given a bigger role to feedback from past inflation. That said, inflation has been trending down for the past two decades across developed and developing economies alike. The inevitable conclusion is that there are global forces putting downward pressure on inflation, and it is not just the result of better monetary policy.”

 

Figure 1
Phillips curve across OECD countries by decade

 

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From Econbrowser:

“Or, old fogey downloads data, finds a negative relationship, a.k.a. the Phillips Curve…

Much was made of the meeting of minds of AOC and Larry Kudlow regarding the Phillips Curve, to wit (from Bloomberg):

… Ocasio-Cortez said many economists are concerned that the formula “is no longer describing what is happening in today’s economy” — and Powell largely agreed.

“She got it right,” Kudlow told reporters at the White House later on Thursday. “He confirmed that the Phillips Curve is dead. The Fed is going to lower interest rates.”

Well, since I’ve been teaching the Phillips Curve for lo these thirty odd years, I thought I’d check to see if I’d missed something. First, it’s important to remember that while we talk about the negative relationship between inflation and unemployment, or the positive relationship between inflation and output, the actual model we use is the expectations augmented Phillips curve including input price shocks. My preferred specification is:

π_t = π^e_t + f(u_t-4 – u_n,t-4) + θz_t

Where π is 4 quarter inflation, π^e is expected inflation, u is official unemployment rate, u_n is natural rate of unemployment [ so (u-u_n) is the unemployment gap], and z is an input price shock, in this case the 4 quarter inflation rate in import prices. Each of these series is available from FRED; using the FRED acronyms, PCEPI for the personal consumption expenditure deflator, MICH for University of Michigan’s 1 year inflation expectations, UNRATE for unemployment rate, NROU for natural rate of unemployment, and IR for import prices.

Estimate this relationship using OLS over the 1987-2019Q2 period (first two months of 2019Q2 used to proxy for Q2). This sample period, after accounting for lags, spans the “Great Moderation”.”

From Conversable Economist:

“As Americans recover from our annual April 15 deadline for filing income taxes, here are a series of figures about longer-term patterns of taxes in the US economy. They are drawn from a series of blog posts by the Tax Foundation over the last few months.  The Tax Foundation is a nonpartisan group whose analysis typically leans toward side that taxes on those with high incomes are already high enough. However, the figures that follow are compiled from fairly standard data sources: IRS data, the Congressional Budget Office, and the like.

For example, here’s a figure showing what taxes are the main sources of federal income over time from Erica York. She writes: “Before 1941, excise taxes, such as gas and tobacco taxes, were the largest source of revenue for the federal government, comprising nearly one-third of government revenue in 1940. Excise taxes were followed by payroll taxes and then corporate income taxes. Today, payroll taxes remain the second largest source of revenue. However, other sources have shifted in relative importance. Specifically, individual income taxes have become a central pillar of the federal revenue system, now comprising nearly half of all revenue. Following an opposite trend, corporate income and excise taxes have decreased relative to other sources.”

 

From a new IMF working paper by Jean-Marc Natal and Nicolas Stoffels:

“We argue that strong globalization forces have been an important determinant of global real interest rates over the last five decades, as they have been key drivers of changes in the natural real interest rate—i.e. the interest rate consistent with output at its potential and constant inflation. An important implication of our analysis is that increased competition in goods and labor market since the 1970s can help explain both the large increase in real interest rates up to the mid-1980s and—as globalization forces mature and may even go into reverse, leading to incrementally rising market power—its subsequent and protracted decline accompanied by lower inflation. The analysis has important implications for monetary policy and the optimal pace of normalization.”

From an article by Christopher G. Collins (PIIE) and Joseph E. Gagnon (PIIE):

“The US economy is running hot, with a record high rate of job vacancies and the lowest unemployment rate in nearly fifty years. Yet most forecasters predict no increase at all in inflation. This combination appears to challenge the validity of the Phillips curve, a popular economic model dating from the 1950s that predicts rising inflation when unemployment is low and falling inflation when unemployment is high. In a new paper, however, we show that the relationship between inflation and unemployment has shifted twice—in the late 1960s and in the mid-1990s. The paper replicates the findings of some other researchers, who find a very flat Phillips curve since the 1990s, implying that unemployment has little effect on inflation. But we also propose an alternative hypothesis: The Phillips curve is bent when inflation is low so that high unemployment has little downward effect on inflation, but low unemployment still pushes inflation up. If we are right, inflation is likely to rise modestly over the next couple of years. We will explore what this means for monetary policy in a subsequent post.

THE EVOLVING US PHILLIPS CURVE

Alban Phillips (1958) developed the original curve bearing his name. It related the rate of wage inflation to the unemployment rate in the United Kingdom over the period 1861–1913. Olivier Blanchard (2017, chapter 8) showed that a similar downward-sloping curve in terms of price inflation and unemployment was apparent in the United States in 1900–1960. Our paper confirms Blanchard’s finding that the rising inflation of the late 1960s led to the unmooring of expectations of inflation from the stable low levels that had prevailed before then and a shift in the Phillips curve to a relationship between the change in the rate of inflation and the unemployment rate. The return of inflation to a very low and stable level led to a second shift in the Phillips curve in the mid-1990s, back to a relationship between the level of inflation and the unemployment rate.

In addition to this shift in the persistence of inflation, many researchers have found that the Phillips curve has been very flat since the 1990s, so that changes in unemployment have little effect on inflation. This was most dramatically demonstrated in the aftermath of the Great Recession of 2008–09, when unemployment remained very high for years and yet inflation barely dipped. We show, however, that another hypothesis fits the data equally well: The Phillips curve may become bent when inflation is low, with a flat portion for high unemployment and a steeper portion for low unemployment.”

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