The Crooked Path of Central Banks


Who Killed the Phillips Curve? is the name of a paper by the US Fed's economists. The IMF, central banks and leading macroeconomists are all trying to understand what has happened to it and their interest is not theoretical at all. The answer to this question determines quite a lot, in particular, how much central banks should tighten their policy in order to curb inflation that has broken out of control.


The world has not seen such a rapid monetary policy tightening since the early 1980s, when the US central bank was struggling with the Great Inflation of the previous decade. On September 21, 2022, the Federal Reserve raised the federal funds rate by 75 bp for the third time in a row and announced its intention to continue increasing the costs of borrowing.

Even though the interest rate has already gone up from 0-0.25% at the beginning of the year to 3-3.25%, the highest level since the crisis of 2008, inflation doesn’t seem to react to the efforts of the central bank and brings mixed news. In August, the consumer price index rose by 8.3% year-on-year, slightly less than in July (8.5%), but more than was expected (8.1%). Inflation expectations decreased, but core inflation (excluding food and energy prices) accelerated to 6.3% from 5.9%.

The fact that the monetary tightening has not yet led to the desired result is clear from the situation on the labor market. The unemployment remains close to the lowest level in more than half a century despite a slight increase in August (from 3.5 to 3.7%). At the same time, the number of vacancies in the US remains extremely high.

In its fight with inflation, the Fed cannot influence some important factors that have caused it and remain beyond its control, noted Eoin Treacy, strategist of the Fuller Treacy Money Global Strategy Service. They include problems in global supply chains, and high global energy and food prices which are growing, in particular, due to the armed conflict in Ukraine. Therefore, in order to reduce inflation, the Fed can only suppress demand by aggressively raising the interest rate, Treacy said.

And so, the regulator is doing this. After the last meeting, Fed Chair Jerome Powell warned that the key rate will continue to rise until unemployment is high enough to suppress demand (and slow down inflation as a result). Before now, for almost a decade, the Fed had been doing the exact opposite: it pursued an ultra-soft monetary policy to reduce unemployment and stimulate price growth, since deflation threatened the economy after the 2008 financial crisis. However, despite the improvements in the labor market, near-zero interest rates, and a multiple increase in the Fed balance sheet due to asset purchases, inflation has not gone up.

It took the Covid pandemic for the situation to change.


How Did the Curve Flatten?

The interaction between inflation and unemployment is usually described by the Phillips Curve, which illustrates their inverse relationship. Central banks use it to build their models. Broadly speaking, it shows the relationship between inflation and economic activity.

However, the dependence found by William Phillips in 1958 (in the original version it showed the relationship between price changes and wages) failed to prove itself already in the 1970s during the Great Inflation, or stagflation, when prices were rising rapidly and unemployment could not be reduced. This discrepancy was explained (or rather, predicted) by economists Milton Friedman and Edmund Phelps, who in their 1968 articles presented the hypothesis of the natural unemployment rate, explains Oleg Zamulin, a lecturer at the College of Literature, Science and the Arts at the University of Michigan. According to this hypothesis, there is structural unemployment in the economy, and it is useless to try to change it with the help of a policy stimulus.

The following decades again questioned the dependence on the Phillips Curve, but in a different way. During the Great Recession, unemployment dropped from a 25-year high of 10% in 2009 to an almost 50-year low of under 4% by the end of the 2010s. But inflation did not react much and remained slightly below the Fed's goal of 2%, the authors of What’s Up with the Phillips Curve? note. The paper was written by four researchers including representatives of the Federal Reserve Bank of New York and the European Central Bank for the Brookings Institution. Moreover, inflation has remained fairly stable since about 1990, despite the changing dynamics of economic activity, they also point out.  

The authors explain the impressive price stability of the recent decades by a muted impact of cost on inflation, including changes in wages, or, in economic jargon, by a flattening of the Phillips Curve. This could be caused by many structural factors, such as the increased relevance of global supply chains, heightened international competition, and other effects of globalization, the researchers write.

Economists from the Fed Board of Governors identify another factor in their research Who Killed the Phillips Curve? A Murder Mystery. According to their estimates, the decline of trade union power in the US since the 1980s reduced their ability to achieve wage increases (which leads to the inflationary spiral: as wages are rising companies start to increase prices to compensate for costs, and then, in turn, inflationary expectations increase together with demands to raise wages, and so the spiral goes on).

As a result, a rather flat Phillips Curve has been incorporated into economic models of recent decades, the IMF Chief Economist Gita Gopinath notes, adding that it was clearly confirmed by the empirical evidence and experience after the 2008 crisis, when many countries managed to reduce unemployment to multi-year lows, while inflation and inflation expectations remained below the central banks' goals. But such models failed to explain the recent surge in inflation and predicted a much smaller acceleration of core inflation than was actually the case, Gopinath admits. Taking into account this experience, it is necessary to reconsider the effectiveness of strategies based on a flat Phillips Curve, including active stimulation of demand and ignoring temporary supply shocks, she believes.

A flatter Phillips Curve may indicate that economic activity has less impact on inflation, writes Filippo Occhino, associate professor of economics, Coles College of Business, Kennesaw State University, and a former employee of the Federal Reserve Bank of Cleveland. This complicates the Fed's task and forces the world's largest central bank to act harshly to stifle demand in order to reduce inflation. Powell made it clear that at the November meeting, the rate could rise by another 75 bp. This is indicated by the Federal Open Market Committee dot plot: the Fed’s officials now expect that by the end of the year the key rate will be 4.4% and reach 4.6% in 2023 (median estimates).

High employment means a possible increase in the potential upward pressure on wages and prices, the World Bank wrote in a June report. The influence of the factors noted by the authors of the two above-mentioned papers about the Phillips Curve is also weakening. Trade unions are gaining strength: this year saw the birth of the first trade union at Amazon, while Starbucks, Apple and Google are on the way. Although it is still difficult to say how influential they will be in negotiations with management, the number of strikes demanding a wage increase is growing. In mid-September, a nationwide strike of railway workers was prevented only after the intervention of president Joe Biden. If it had happened, another break in supply chains could have spurred inflation. However, the deal between the workers and the employer can also contribute to it since wages will be increased by 14.1%, and additional payments and benefits are expected.

On the global stage, the aggravation of geopolitical conflicts can lead to a decline in economic efficiency along with an increase in prices and costs. Companies are starting to re-shore production or move it to more friendly countries that can make it more expensive. And China, the world's main exporter, has long ceased to be a country with cheap labor. Meanwhile, transaction costs may increase following the development of national payment systems, including for the sake of reducing the risks of financial sanctions.


What does this all mean for the economy?

One does not only need to know that the Phillips Curve has flattened, it is necessary to understand exactly why this has happened, Occhino says, adding that the central banks’ policy depends on it. Structural factors (a decrease in the effect of globalization and changes in the labor market) are beyond the Fed’s control and its aggressive policy must necessarily lead to an increase in unemployment – without this it will be impossible to overcome inflation now, says Olivier Blanchard, former IMF chief economist and now a senior fellow at the Peterson Institute for International Economics.

Due to the labor market imbalance, the natural unemployment rate, which was about 3.5% before the pandemic, has now shifted to about 4.5-5%, he estimates together with economists Alex Domash and Larry Summers. Today, the economy is overheating, Blanchard said in an interview with Goldman Sachs. Therefore, in order to bring inflation closer to the target (2%), the Fed has to achieve an increase in unemployment (especially if prices for energy resources and other commodities do not go down) to a level exceeding the new natural one – perhaps, 6%, the economist believes. In fact, his estimates mean that the Phillips Curve has moved away from the flat state that Gopinath was talking about.

Jan Hatzius, Goldman Sachs chief economist, doesn't quite agree with Blanchard. He believes that it will be possible to cool the labor market (and inflation) by reducing the number of job vacancies and a slight increase in unemployment (up to 4% by the end of 2024). Although, according to Blanchard, there are no historical precedents for this (job vacancies and employment fall simultaneously, albeit with some lag), Hatzius says that there were no precedents of Covid either and the imbalance provoked by it begins to disappear.

In addition, he points out a significant decline in commodity prices in recent months, as well as normalization of supply chains and decreasing demand for goods that provoked problems before. All this will begin to be reflected in the consumer price index in the coming months, Hatzius believes.

The flattening of the Phillips Curve could be caused not only by structural changes in the economy, but also by changes in monetary policy in recent decades, which focused on stable inflation, Occhino says. In the first case, central banks really need to have a stronger impact on the unemployment rate to combat inflation, and a smaller one in the second case. And this could be good news for the economy.


By Mikhail Overchenko