The Phillips curve was developed by the British economist A. W. Phillips in the 1940’s. It states that there is an inverse and stable relation between unemployment rate and inflation rate. Phillips did not develop a theory for this tradeoff but based it on historical data. This curve was challenged in the 1970s when rising inflation expectations had shaken this curve as inflation had risen for a given rate of unemployment—that is, the curve moved up while the unemployment rate stayed constant.
Given that the current high inflation in the U.S. exceeded 8% in September 2022, while the unemployment rate hovers around 3.5%, this situation has resurrected the memories of the 1970s about the Phillips curve. The Federal Reserve (Fed) currently considers this elevated inflation the number one economic enemy. This was helped further by the fact that the Fed considered inflation to be “temporary,” but the real world proved it wrong. Thus, the Fed has been behind the curve and now is playing the catchup game. These days, the Fed seems to accept much higher unemployment to reduce inflation. Socially, this is not acceptable—particularly by those who lose their jobs, but the Fed ignores that. In fact, the Fed justifies that by thinking that unemployment affects a group of people but inflation affects all people.
How is the Phillips curve in 2022 different from the Phillips curve in the 1970s? The difference is in the inflation expectations. While the yield curve has been inverted as the one-year interest rate is higher than the 5-year rate and the latter is higher than the 10-year rate, which usually portrays recessions, the current low inflation expectations are still entrenched (stable). Un-entrenched expectations will bring the memories of the 1970s which experienced stagflation. Thus, inflation expectations are not now shifting the Phillips curve upward for any given rate of unemployment as they did in the 1970s. This should make the Fed’s job easier than in the 1970s which ended in two back-to-back bad recessions in 1980 and 1981 and when the unemployment rate climbed to 10.8% in March 1982.
But why is the current Fed so concerned with the current inflation? They have increased the federal funds rate by a hefty 75 basis points three times in a row and are willing to do more in the future. The Fed is behind the curve in increasing the borrowing costs and worried about inflation expectations which, if they get loose, will require the implementation of a brutal monetary policy as Paul Volcker did in the early 1980s. If that happens, the social and financial costs will be much higher.
The labor market is playing a role in complicating the path of the current monetary policy here in the U.S. which also has ramifications for the whole world, particularly developing countries. Since inflation expectations are entrenched and inflation keeps moving up, then the Phillips curve is not adequate enough for the Fed to rely on. The Fed should also consider the labor market and the Beveridge curve, which portrays a tradeoff between the number of vacancies and the number of the unemployed. The high number of vacancies over the number of the unemployed accounts for three quarters of the monthly core price inflation, according to an index developed by the Federal Reserve Bank of Cleveland. This curve provides evidence that the labor market is still red hot and the Fed should continue to pursue a contractionary monetary policy by raising the federal funds rate until the unemployment rate reaches 5 percent, according to prominent economists. This means the Beveridge curve should complement the Phillips curve and both should be considered together in policy making.
In conclusion, U.S. monetary policy is now more complicated than it has been in the last four decades. Some economists such as Claudia Sahm, who developed the Sahm rule for dating the beginning of recessions, also want to add financial stability to the Fed’s two mandates (full employment and price stability) which would add another dimension to the complicity of monetary policy. However, the current Federal Reserve is focusing on one mandate which is fighting inflation.
Shawkat Hammoudeh, Ph.D.
Professor of Economics & International Business