By Michael Owyang, Assistant Vice President and Economist
Tight labor markets (i.e., a low unemployment rate) typically lead to upward pressure on wages and inflation. This relationship is embodied in the Phillips curve, which is generally plotted with unemployment on the x-axis and inflation on the y-axis with the negative relationship implying that the curve slopes downward.
Over the years, economists have discovered that the Phillips curve appears to shift. These shifts are typically attributed to changes in inflation expectations and were thought to have contributed to the period of high inflation and high unemployment in the late 1970s.
Recently, economists have questioned whether the Phillips curve relationship has broken down. As the unemployment rate has fallen during the recovery from the Great Recession, the inflation rate has stayed low, below even the Federal Reserve’s target. If a Phillips curve relationship still exists, the three most probable explanations for the aforementioned phenomenon are that:
The figure below plots the Phillips curve over the period January 2010 through June 2015. It shows the apparent flatness of the Phillips curve. (A graph of these data over the period January 1985 through January 1994 provides an example of a steeper Phillips curve.)
The next figure shows the five-year, five-year-forward breakeven inflation rate1 along with the Congressional Budget Office’s (CBO) estimate of the natural rate of unemployment. This figure shows that five-year, five-year-forward inflation expectations have been falling on pace with the natural rate of unemployment.
As this expectation falls, the intercept for the Phillips curve shifts down and pulls the curve inward. This shift could be another potential cause of the seemingly flat Phillips curve. Starting in January 2015, inflation expectations began to creep up, but it is too soon to know yet if this increase will continue.
The second figure also shows that the CBO’s estimate of the natural rate of unemployment began to fall in 2014. The actual unemployment rate didn’t cross below the CBO’s rate until June 2015, which (assuming the CBO’s estimate of the natural rate is correct) means there is not yet upward price pressure. Any further reductions in the unemployment rate below the natural rate would translate to increased prices if the Phillips curve relationship still holds.
However, there is one caveat about this conclusion. The CBO’s estimation of the natural rate likely builds in a version of the Phillips curve relationship. Thus, their natural rate may move a way that will always return to the Phillips curve if used in external regressions. Any conclusions made using these data should be interpreted with caution, as they may be tautological.
These two alternate explanations suggest the current flat shape of the Phillips curve is only temporary. However, as both alternate explanations for a flat Phillips curve seem to be expiring, economic data over the next year could be very important to assess the continued validity of this macroeconomic relationship.
1 The five-year, five-year forward break-even inflation rate measures what the difference between nominal and real interest rates is expected to be over the five-year period starting in five years from the point measured.