An interesting Economist economic focus column this week. Curve ball: A link between unemployment and inflation is fashionable again
If haircuts and dress styles can come back into fashion, then so can economic theories. That is why policymakers have recently been debating the implications of the shape of that very 1960s concept, the Phillips curve.
The Phillips curve was named after A.W. Phillips, whose research suggested a trade-off between British unemployment and wage inflation over the period 1861 to 1957. The curve was widely used in the 1960s. Economists developed models that gave politicians a neat way to find the right balance between the two factors; for every percentage-point fall in unemployment, inflation would rise by, say, half a point.
But in the 1970s, the trade-off between unemployment and inflation seemed to evaporate; both rose at the same time, a phenomenon known as stagflation. ...Even before the curve began to break down in practice, Milton Friedman had cast doubt on the theory, as had Edmund Phelps, another American economist. The doubters argued that workers would demand higher wages to protect themselves against the rise in inflation. Thus the only effect of government stimulus would be to increase inflation for the same level of employment; in the long run, the Phillips curve became vertical.
So the Phillips curve fell out of favour and was replaced by its corollary, the NAIRU, or non-accelerating inflation rate of unemployment (in effect, the natural rate). Economists spent much of the 1980s and 1990s debating what the rate might be.
...Why has the Phillips curve, displaced by the NAIRU and the output gap (which suggests that inflation will rise when economic growth is above trend), come back into the economic debate after so long in the cold?
In part because, while the NAIRU and the output gap are nice ideas, it is often hard to agree, at any given moment, on the value of either number. But the main reason is that the relationship between unemployment and inflation has settled down again. Low unemployment has not been accompanied by significant increases in inflation; in other words, the Phillips curve has flattened considerably.
Most commentators have put this down to globalisation. As Paul McCulley, a strategist at PIMCO, a large American fund-management firm, remarks in his latest commentary: “The Fed need not worry that a falling US unemployment rate will quickly generate a rapid acceleration in US wage-driven inflation, as US labour's pricing power is diminished by competition from an augmented global labour supply.”
A flatter Phillips curve is good news when unemployment is falling. But it also implies bad news if inflation rises significantly. It would then take a much larger increase in unemployment (a more severe recession) to bring inflation down again. This may explain why the European Central Bank has found it so difficult to get euro-zone inflation back below its target of 2%.
This is where the credibility of a central bank may matter a lot. If consumers believe the central bank will keep inflation low, then they will not react to temporary shocks (such as high oil prices) by demanding higher wages.
...That makes it all the more important to decide exactly why the Phillips curve has flattened. In particular, are central banks responsible for the favourable trade-off between unemployment and inflation over the last ten years? Or, as Ken Rogoff of Harvard University suggested recently*, have policymakers merely had a dash of luck: that globalisation happened to coincide with the independence of central banks?
If the answer is luck then central banks need to be on their guard, especially as headline rates of inflation have been rising recently. Some, including the Bank of England, seem to have recognised this problem. They say that while globalisation has caused the prices of manufactured goods to fall, the corollary has been that sharply higher demand for raw materials has caused commodity prices to rise sharply. Core inflation numbers, which exclude food and energy, may thus reflect the good news about globalisation, but ignore the bad.
The Federal Reserve may focus on the low core rate of inflation but workers may be watching the headline numbers, which in most countries have been significantly higher. The sharp drop in oil prices in recent weeks may reduce this differential, but could easily be reversed by supply disruption or a harsh winter.
If workers begin to focus on the effect of higher commodity prices on their spending power, and regard the effect as permanent rather than temporary, then they may push up their wage demands. That could lock higher inflation into the system, giving central banks a devil of a job to bring it back down again.
Very interesting indeed ...
And Rogoff is cited for his 'chicken and egg' argument about globalization and central banks ... good stuff. This one definitely merits some further thought.
Oh and the link is not right (I think) ... this should be the right one;
http://www.economist.com/finance/displaystory.cfm?story_id=7967976
Posted by: claus vistesen | Friday, September 29, 2006 at 01:23 PM
"“The Fed need not worry that a falling US unemployment rate will quickly generate a rapid acceleration in US wage-driven inflation, as US labour's pricing power is diminished by competition from an augmented global labour supply.”
Yes, that is one reason. But, it depends ...
Labor that has shifted abroad is typically unskilled or semi-skilled labor, employed in production (manufacturing, assembly, etc.) These wage rates typically depend upon union negotiations and are over a long period of time. The jobs that are lost certainly wont affect the inflation rate, except in the manner that the re-employed will have substantially lower wage rates when they exit the manufacturing sector and go into the services sector(at McDonald's, for instance). So, the effect is to lower generally wage levels.
However, skilled labor (programmers, electricians, plumbers, construction workers, and trained staff) will suffer from the tightening of the offering as employment increases. These jobs normally show wage increases under such conditions.
And, I suspect that it is the latter and not the former sector that will prevail. The "China effect" is perhaps very much behind us. The jobs that were going have gone.
Now, as China climbs the skilled-labor ladder, its more and more skilled labor force will compete on international markets. What will happen?
We have a precursor that indicates what might happen. Two in fact, Japan and Korea. Did skilled labor in Western Europe and America suffer seriously from the competition of these two nations in the 1980s and 1990s? Somewhat but not as much as unskilled labor.
And not for as long as both regions can count on productivity gains, so essential to competitiveness. The race in productivity has just begun.
So, economic national priorities, particularly fiscal, should focus on productivity gains. Will they? Not for as long as Europe is a cacophony in terms of national fiscal policy making. For America, fiscal policy will be favorable towards productivity gains, since they appreciated the necessity of it some time ago.
Posted by: A. PERLA | Friday, September 29, 2006 at 02:02 PM
As long as everyone remembers that you don't just have to move along curves, you can shift them too. The return of the supply side!
Also, this is exactly the basis that Layard's work on cutting long term unemployment (what became welfare reform in the US) used as a justification. That worked pretty well.
Posted by: Tim Worstall | Friday, September 29, 2006 at 02:41 PM
The Economist: "The doubters argued that workers would demand higher wages to protect themselves against the rise in inflation. "
We have a tendency, a bit too much, to look for THE smoking gun. The above is just such an instance.
In an economy with rising inflation, and if in a country like that links wages to inflation automatically (as did Italy with its stupid "scala mobilé" once upon a time), then, yes, unions ask for wage increases that keep pace with inflation ... without understanding that they are simply furthering it.
Linking wages to inflation is suicidal. It simply promotes more inflation. So, the policy objective is not to convince unions to reduce thier wage demands (for which Europe has a particular talent by enjoining talks directly between the state and labor unions).
It is to control inflation by fiscal means. This can mean reduced taxation, but more than likely what does the trick is fiscal enticement for productivity gains (in the form of accentuated amortization of technology related expenditures).
What has changed the context, and the German unions seem to have begun to understand, is that globalization has reduced thier negotiating clout. The unions in car manufacturing negotiated themselves out of thier jobs in the 1990s with exorbitant pay rises when pay rises were thought to be systematically forever. They are now accepting reluctantly increased time on the job for the same pay - thus reducing hourly wage rates.
But unions represent, in fact, only a minority of the working population. What about the rest of us? No man (or woman) is an island in today's intricately complex, modern economy. We learn that running in place might be more wise, perhaps, than running off in the pursuit of a higher pay in a job that might prove as lasting as the morning dew.
The qualified worker today is an intelligent being that senses the ambient changes in the work market, perhaps better than any generation in the past. And, as more of us become Information Workers, our sensors can only get better.
What's the point? This: The education of "work related" skills is becoming increasinly more imperative, more so than the pursuit of knowledge in areas less related to the needs of the labor market.
Philosophy majors should not be astounded that McDonalds is the only company that cares to hire them out of university. (8 ^ 0)
Posted by: A. PERLA | Friday, September 29, 2006 at 02:49 PM
I just read the Wiki note on the Philips curve, which totally ignores Friedman's monetary theory about controlling inflation thru controlling the money supply (in practice, Central Banks adjusting interest rates).
It occurs to me there are two gov't controllable inflation-employment influences: monetary and fiscal; plus the exogenous globalized system labor & commodity markets, especially oil/gas-energy.
Friedman's monetarism has mostly "won" the stable inflation target reduced money supply fluctuations, and most central banks push for stable price levels (=stable money growth). In this stable money environment, perhaps national fiscal policies recreate a fiscal-inflation / unemployment relationship (welcome back, Mr. Phillips).
(see http://en.wikipedia.org/wiki/Phillips_curve )
Posted by: Tom Grey | Saturday, November 25, 2006 at 09:53 AM
I like to know what is the phillips curve because I've got a presentation please give me this leter.Thank you
Posted by: ttt | Sunday, November 18, 2007 at 01:13 AM