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What Ever Happened to the Phillips Curve? Interpreting a Half Century of Inflation and Unemployment

A couple of weeks ago, I wrote a post on the Fed’s success, or lack thereof, in meeting its dual targets of 5.5 percent unemployment and 2 percent inflation. The post featured the following “bullseye” chart, which had first come to my attention when Chicago Fed President Charles Evans used it in a recent speech. James Hamilton has since used the same type of chart on Econbrowser. It is a handy graphical device that looks likely to catch on.

The axes on the chart show the unemployment rate and the inflation rate, as measured by the Fed’s preferred index for Personal Consumption Expenditure (PCE). An alert reader of my post commented that the axes are the same as those for a Phillips curve, yet the recent trend, shown by the arrow, has a negative slope, exactly the opposite of what the classic Phillips curve supposes. What is going on? Whatever happened to the Phillips curve?

What the raw data do (or don’t) tell us

The original paper by A. W. H. Phillips, published in Economica in 1958 (downloadable here) showed an impressively close inverse relationship between inflation and unemployment for the British economy up to World War I, as shown in the next chart. It also noted a similar, if slightly messier, relationship for the interwar years.

However, if we make the same kind of chart for the US economy over the past half-century, we see essentially no correlation. The R2 is an insignificant .006 and the faint trace of a trend, if we draw it in, runs in the wrong direction.

If that had been all there was to see, popular writers, policymakers, and some academic economists would never have seized on the Phillips curve as they did in the 1960s. They never would have declared it a policy menu that allowed policymakers to choose a combination of inflation and unemployment that suited their political tastes. The curve never would have survived for fifty years as a staple of college textbooks. To understand why the Phillips curve made such an impact, and to judge whether there is anything left of it, we have to make a much closer interpretation of the data. Here goes.

The Kennedy-Johnson years

The Phillips curve was at the height of its popularity when John F. Kennedy became president in 1961. Kennedy had been elected on a promise to “get the country moving again.” He and his successor, Lyndon Johnson, set out to do so with the help of some of the best and brightest economists of the day. We can catch the spirit of that self-confident decade in this passage from the 1966 Economic Report of the President, written by a Council of Economic Advisers consisting of Arthur Okun, Gardner Ackley, and Otto Eckstein:

We strive to avoid recurrent recessions, to keep unemployment far below rates of the past decade, to maintain price stability at full employment . . . and indeed to make full prosperity the normal state of the American economy. It is a tribute to our success . . .  that we now have not only the economic understanding but also the will and determination to use economic policy as an effective tool for progress.

The result of their efforts at economic stimulus was something that, at least at first, looked very much like the classic Phillips curve, as we see in this next chart:

The only bothersome part of the 1960s expansion was the fact that the tradeoff between unemployment and inflation appeared to getting less favorable over time. As that became increasingly apparent, Milton Friedman and Edmund Phelps, among others, proposed an explanation. The the positively sloped Phillips curve, they suggested, is only a short-run relationship. The long-run Phillips curve is better represented as a vertical line at the economy’s natural rate of unemployment. In the Friedman-Phelps version, the short-run Phillips curve shifts up and down along the long-run vertical curve as the expected rate of inflation changes.

The shifting Phillips curve and the stop-go cycle

The next chart shows the dynamics of inflation in a simple version of the shifting Phillips curve model. The long-run Phillips curve is vertical at the assumed natural unemployment rate of 5 percent. The figure includes three short-run Phillips curves, each intersecting the long-run curve at the corresponding expected rate of inflation.

In this simple version of the model, we assume that each year’s expected rate of inflation is equal to the previous year’s observed rate. The observed rates of inflation and unemployment for each year are jointly determined by the position of the short-run Phillips curve and the rate of growth of aggregate nominal demand. Finally, we assume that policymakers alternately apply expansionary measures when they feel political pressure to “do something” about unemployment and contractionary measures when they are pressured to do something about inflation.

Putting all of these assumptions together produces a dynamic in which the economy moves in a clockwise direction around an irregular loop. Starting from equilibrium at point A, with moderate inflation and unemployment at its natural rate, suppose that fiscal or monetary stimulus increases the growth rate of aggregate nominal demand. With inflation expectations still anchored at 2 percent, the economy moves up along SRP1 to point B, where unemployment falls to 3 percent and observed inflation rises to 4 percent.

The 4 percent inflation observed at point B raises the next year’s expected inflation to 4 percent, shifting the short-run curve upward to SRP2. Assuming continued expansionary policy, the economy next moves to point C.

At point C, inflation is a worrisome 6 percent. The government must do something, so it puts on the fiscal and monetary brakes. However, the economy can’t simply slide back down along SRP2, because the 6 percent inflation observed at point C has shifted the short-run curve upward again to SRP3. Instead, contractionary policy pushes the economy across to point D. We get the dread “stagflation” scenario where unemployment rises even as the rate of inflation remains stubbornly high.

If the authorities have the political fortitude to stick to a contractionary policy, they can eventually purge the economy of inflation. In the next year, the economy would slide down along SRP3 to point E. At that point, observed inflation is finally less than expected, so the short-run Phillips curve begins to shift downward. In theory, skillful policy could steer the economy back to a soft landing at point G, right where it started.

Simple though it is, the inflationary dynamics of this model correspond remarkably well to the behavior of the US economy over the two decades following Kennedy’s inauguration. The next chart plots the actual data. The main difference between the historical pattern and the stylized version is that the loops of the historical stop-go cycle seem to drift upward over time. A reasonable explanation would be that policymakers react more rapidly and more strongly to political pressures to reduce painfully high unemployment than to subsequent pressures to reduce unwanted inflation.

The Great Moderation

Just as it seemed that the stop-go cycle with an inflationary bias might become a permanent feature of the US economy, vindicating the shifting Phillips curve model, the picture changed. The US economy entered a 20-year period now known as the Great Moderation. As the next chart shows, during that period the unemployment and inflation rates stayed remarkably close to the bullseye defined by the Fed’s current targets of 5.5 percent unemployment and 2 percent inflation.

During the Great Moderation, the looping stop-go cycle so evident in the 1960s and 1970s becomes both diminished and more irregular. It is hard to tell if the Phillips curve has disappeared entirely in this period, but if it is still there, its effects seem to be obscured by random shocks. The correlation of inflation and unemployment is faintly positive and the R2 of just .025 is insignificant.

From the Great Moderation to the Great Recession

The Great Moderation ended with the Great Recession, which began in late 2007. The next chart compares the most recent data to the behavior of the economy in the 1960s and 1970s. To sharpen the focus, this chart differs in two ways from our earlier ones. First, it shows quarterly rather than annual data. Second, it shows data only for the trough-to-peak phases of the business cycle (recovery and expansion), leaving out quarters in which GDP decreases. Because the main purpose of the chart is to compare the recent expansion with those of the 1960s and 1970s, when the shifting Phillips curve model was clearly operating, it omits the four cyclical recoveries between 1980 and 2006.

The three earlier cycles are similar in certain ways that we can explain easily in terms of the shifting Phillips curve model.

First, the earlier recoveries all begin with a phase during which the rate of inflation begins to fall while the unemployment rate is still rising. In the shifting Phillips curve model, that pattern can occur when tight fiscal and monetary policy restrain the growth of aggregate nominal demand while falling inflation expectations are shifting the short-run Phillips curve progressively downward. According to the model, the rate of unemployment should still be above the natural rate during this phase of the recovery, as it appears to be. The CBO estimates that the natural rate rose from about 5.5 percent in 1960 to about 6.5 percent by 1980, which would explain the rightward drift in the first three recovery tracks shown in the chart.

Second, in each of the three early cases, inflation and unemployment both begin to rise no later than seven quarters into the recovery. The subsequent segments are the ones that look superficially like classic negatively-sloped Phillips curves, but are better explained as the result of expansionary policy acting on a short-run Phillips curve that is shifting upward under the influence of rising inflation expectations. The shifting-curve model suggests that unemployment should fall below its natural rate as inflation accelerates, which seems generally consistent with the data.

Good data on inflation expectations for the 1960s and 1970s would bolster the shifting curve model as an explanation of the patterns followed by the three early recoveries shown in the chart. Unfortunately, data on expectations for those years is skimpy. In an attempt to fill the gap, a recent study by Jan Groen and Menno Middeldorp of the New York Fed attempts to construct a proxy series for inflation expectations that reaches back to the 1970s. Their reconstruction is consistent with the notion that inflation expectations fell in the early part of the recovery of 1975 to 1980, but it does not go back far enough to cover the two earlier recoveries.

Let’s turn now to the recovery from the Great Recession, which began in mid-2009. Its pattern is very different. As in the early cycles, the unemployment rate lags behind GDP and continues to rise in the first few quarters of the recovery. However, in this case, the rate of inflation rises, rather than falling, in the early part of the recovery. It does not reach its mid-recovery peak of 2.9 percent until the third quarter of 2011.

During the whole period from Q3 2009 to Q3 2011, unemployment is far above its natural rate. It is impossible to produce the combination of rising inflation together with unemployment that is both rising and above the natural rate with a simple shifting Phillips curve. In that model, unemployment can be above the natural rate only if the observed rate of inflation is less than the expected rate, and that, in turn, would cause a steady downward shift of the short-run Phillips curve from quarter to quarter. Under those circumstances, either the unemployment rate or the inflation rate would have to fall from quarter to quarter.

After Q3 2011, the current recovery takes a different direction. From then until the most recent observations, the trend has been falling unemployment combined with falling inflation. It is technically possible to produce that result in the shifting Phillips curve model if we combine an unemployment rate initially above the natural level, falling inflation expectations, and demand management policy that is gradually becoming more expansionary. A few short segments  seem to fit that pattern during the earlier cycles, most notably the period from the fourth quarter of 1975 through the fourth quarter of 1976.

The problem is that there is no evidence of falling inflation expectations in the most recent period. If anything, as the next chart shows, inflation expectations have been gently rising from mid-2011 to the present. Without falling inflation expectations, the shifting Phillips curve model is incapable of producing a sustained period during which both the inflation rate and the unemployment rate decrease.

The bottom line

This post began with the question, What ever happened to the Phillips curve? We now have our answer.

The classic stationary Phillips curve—the version that people once optimistically viewed as a stable policy menu—died long ago. Already by the end of the 1960s, the Friedman-Phelps shifting Phillips curve model had taken its place. In our simplified version, that model has these four components:

  1. A vertical long-run Phillips curve
  2. A negatively sloped short-run Phillips curve that intersects the long-run curve at the expected rate of inflation
  3. An expected rate of inflation primarily determined by observed inflation in the recent past
  4. Aggregate nominal demand as the determinant of the economy’s position along the short-run Phillips curve that applies at any given time

When we combine these assumptions with fiscal and monetary policies that react to alternating political pressures to do something about unemployment and then do something about inflation, the shifting Phillips curve model produces a stop-go cycles very much like observed from the early 1960s through the mid-1980s.

After that, even the shifting version of the Phillips curve runs into trouble. Its usefulness begins to fade already during the Great Moderation, and it becomes altogether incapable of producing the pattern of inflation and unemployment we see during the first five years of the recovery from the Great Recession. The reason appears to be a breakdown of two of its key principles, first, that unemployment higher than the natural rate can occur only when inflation is slower than expected, and second, that inflation persistently slower than expected must cause a downward revision of expectations.

Instead, what we see during the past five years is persistently high unemployment combined with low and stable inflation expectations and a falling observed rate of inflation. If the Phillips curve is not dead, we must at least declare it in a persistent vegetative state from which it will not awaken without some radical change in circumstances.

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14 Responses to “What Ever Happened to the Phillips Curve? Interpreting a Half Century of Inflation and Unemployment”

windrivenMay 12th, 2014 at 12:16 pm

"This post began with the question, What ever happened to the Phillips curve? We now have our answer."

I would like to offer a different answer – or, more accurately, a hypothesis that might explain why the Phillips curve died. To my mind it is both simple and obvious: the Phillips curve explained a relationship that existed in the mostly closed socioeconomic states that existed during Phillips' time series but that are mostly relics now. A century ago most of a nation's production assets and labor existed within its borders. As a nation's employment tended toward 'full employment' competition for the scarce labor resource pushed costs up. But beginning in the postwar period and accelerating in the last 50 years, production assets are easily staged where labor is cheap and plentiful thereby at least partially decoupling national employment status from inflation.

The Phillips curve is likely just as valid today as it was a century ago – so long as it is applied to a substantially closed system. Attempts to apply it to modern, highly interconnected economies seem a misapplication of the underlying principle or a misunderstanding of the factors that drive it.

Ed Dolan EdDolanMay 12th, 2014 at 11:14 pm

Interesting point.

My immediate reaction is that even given your assumptions of increasing globalization, the trigger for any one country's outsourcing has to be a rise in wages. If the Phillips curve were flat at the macro level, so that wages did not rise as unemployment fell, what would be the trigger at the micro level for any firm to move production abroad, especially when the move abroad has some nonlabor costs to overcome? So the scenario I would see, even in a globalized world, would be country A experiences increasing demand, its U falls, its W begins to rise, and the rising W triggers outsourcing. There would still be a Phillips curve in country A, the only effect might be to make it flatter. The globalization effect could not make it positively sloped, in any event.

But don't take that as my final answer, I'll give it more thought.

FelixIntDebMay 13th, 2014 at 5:24 am

Drop 3 outliers from that original graph and the "curve" of import price changes as a function of unemployment looks more like a step-down function with Y values of two straight horizontal lines, abutted at 6% unemployment.

Why does anyone care?

In my naiveté, I fail to perceive how employment and import prices changes would have much more than noise affects on each other, anyway, though if I were forced to choose, I'd want to take the side that lower import prices drive up employment. what with low prices being kinda nice and all.

windrivenMay 13th, 2014 at 9:24 am

"the trigger for any one country's outsourcing has to be a rise in wages"

Not in my experience. Offshoring in the medical devices industry started as a tactic to improve profitability. Minimum wage in the US is $7-something, in MX and CN it is closer to $2.50. Rising wages in the US would arguably increase pressure to offshore. But that isn't how it started, at least in my industry. It was just an easy way to bump net profits.

"especially when the move abroad has some nonlabor costs to overcome?"

Those costs are very much lower than you might imagine. Some radiology groups offshore analysis to Indian radiologists, some CPA firms offshore tax prep. These are done electronically and the non-labor costs are infinitesimal. Many semi-skilled factory jobs require only modest capital investments. Transport is cheap. A 40' container can be moved from Shanghai to LA for a few thousand dollars and a 40' container can hold a lot of iPhones or IV sets.

But my point is getting lost in detail. My argument is that inflation is a national phenomenon and labor used to be. But now labor is largely decoupled from the national level. Increasingly, labor is consumed where it is cheapest. It is a commodity like coal. You buy it from the cheapest vendor. Inflation reflects the purchasing power of a nation's unit of currency. National unemployment is no longer directly coupled to output.

So it is not an issue of the Phillips curve being flat or positively sloped or helical. The relationship between unemployment and inflation that the Phillips curve once described simply doesn't exist anymore (or exists much more loosely than it did 100 years ago).

windrivenMay 13th, 2014 at 9:36 am

"Drop 3 outliers from that original graph and the "curve" of import price changes as a function of unemployment…"

? I haven't carefully graphed this without the outliers but at first approximation the slope would appear to be about the same. I'm also missing your point about import prices. The ordinate is inflation.

Finally, I'm not sure I understand why low prices alone would spur employment. Let's say that 1/2 of a nation's labor was agricultural. Ed comes in with imported food at substantially lower prices. In the short term that would drive UNemployment – at least until the economy rebalanced to soak up the former ag workers. No?

ThomasGrennesMay 13th, 2014 at 2:52 pm

Good analysis. There are also conceptual and measurement problems related to the unemployment rate, including the continued decline in the labor force participation rate.

FelixIntDebMay 13th, 2014 at 7:13 pm

The paper doesn't talk of inflation. It talks of import prices. Or seems to at a quick glance. I may have mis-read.

Well, a place where 1/2 the people lost their jobs because someone started selling a cheaper widget sounds like a pretty particular situation. Hard to generalize from that, other than to note that imposed change is generally disliked by the imposee.

Price inflation or deflation and employment? Maybe the big thing is all the people kept busy rearranging and reacting to prices matching today's situation.

By the way, I like your comments above.

windrivenMay 14th, 2014 at 10:36 am

Felix, I think it is worth a reread. Dr. Dolan is looking at the relationship between unemployment and inflation.

I apologize for the starkness of my example. I am fond of reductio ad absurdum to illustrate a point.

User7786June 10th, 2014 at 11:36 am

Dear Ed, thank you for the great article! It gave my a lot of stuff to think about. But I dont really get the point, why the Phillips curve doesnt work anymore and why unemployment and inflation are not linked anymore. Maybe you could point this out?

Pierre FortinDecember 5th, 2016 at 11:46 pm

Ed: One alternative, in fact the only one that can explain all facts and counterfacts, is that Tobin was right and Friedman was wrong. The long-run Phillips curve may be vertical at inflation rates above 5%, but negatively-sloped and convex at low inflation rates because there is increasing resistance to wage rollbacks. I have tested this hypothesis with 56 years of macrodata for Canada, and it works very well. Friedman is srongly rejected and Tobin passes the test. The paper is published, but the easy link is: http://www.cirpee.org/fileadmin/documents/Cahiers

Simple as "bonjour".

Best to you,

Pierre Fortin