November 24, 2017

News in Charts: The Phillips curve – Rumours of its Death are Greatly Exaggerated

by Fathom Consulting.

“Reports of my death have been greatly exaggerated” is one of Mark Twain’s more frequently referenced quips. Leaving aside the fact that it is a slight misquotation, it is an amusing line, and one that neatly captures Fathom’s belief in the continued validity of the Phillips curve. There is a widespread perception that the relationship between labour market slack and inflation is, at best, diminished and, at worst, no longer intact. Fathom does not subscribe to this view. Instead, we believe that the impact of changes in unemployment on a worker’s remuneration has been masked by a sustained decline in the labour share, and by a reduction in the variability of inflation expectations. None of this implies that the Phillips curve is broken — it is merely hidden!

The Phillips curve is named after Alban William Phillips, whose study of UK wage inflation and unemployment between 1861 and 1957 found an inverse relationship between the two variables. Initially, it was believed that this relationship prevailed over the long term, allowing policymakers to trade higher inflation for permanently lower unemployment. Stagflation in the UK during the 1970s and early 1980s blew this theory out of the water, with inflation and unemployment simultaneously breaching 10%. Nowadays the Phillips curve describes a supposed relationship between some measure of real economic slack, be it unemployment relative to the NAIRU, or output relative to potential, and the degree of upward or downward pressure on some nominal quantity, typically wages or prices.

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In the decades since Phillips published his research, the redefined Phillips curve has become a cornerstone of modern macroeconomic models. By raising or lowering the real rate of interest to affect aggregate demand, and with it the unemployment rate, monetary policymakers were able to exert some influence over the rate of inflation, relative to expectations. It seemed like a very useful tool for managing business cycles, particularly for inflation-targeting central banks. Until now, that is. Since the global financial crisis, unemployment has fallen back close to, or below, its natural rate in many advanced economies. Yet, to date, sustained wage growth has been elusive. This has led some commentators to propose that the relationship is no longer stable, or worse still, that it has ceased to exist altogether. Proponents of this view point to the US, where despite an almost six percentage point drop in unemployment, there has been only a very small increase in wage or inflation.

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In order to better understand the dynamics driving wages, we at Fathom estimated equations linking real wage inflation to the unemployment rate over the period from 1960 to 2008. The estimated equations subsequently overpredicted real wage inflation when used to forecast out of sample across a range of major economies. Why? To start with, inflation-adjusted wage growth will be determined in part by productivity growth — a worker is unlikely to be paid more in real terms, for a given labour share of income, unless he or she is able to produce more. The dearth of productivity growth is an important factor, but not the sole explanation for lower-than-expected real wage growth. Instead, long-term factors putting downward pressure on the labour share are also to blame. Meanwhile, inflation-targeting central banks have been successful in lowering both the level and volatility of inflation expectations in advanced economies. This has caused the Phillips curve to shift down, giving the appearance of its slope having flattened.

The labour share refers to the part of national income that is allocated to labour. A range of issues, such as globalisation, technological developments and de-unionisation have put downward pressure on this share of income in advanced economies in recent decades. While we believe that some of the factors driving down the labour share, such as demographic changes and de-unionisation, have peaked, this background noise has hidden the Phillips curve and made it appear that the impact of labour market slack on wages has disappeared. Trust in your macroeconomic training- that is not, and cannot be, the case.

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