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What killed inflation?

By Robert Samuelson

 

The Phillips Curve is dead; long live the Phillips Curve.

One of today’s economic mysteries is: Why is inflation so low? The unemployment rate is a puny 3.8%. The recovery from the 2007-09 Great Recession is nearly a decade old, just when tight labor markets and strong demand usually push up wages and prices. Yet inflation (measured by the consumer price index) has averaged only 1.5% annually since 2014.

One answer is that the Phillips Curve — the relationship between unemployment and inflation — is breaking down, says a study from the Peterson Institute for International Economics. This complicates life for the Federal Reserve. If the breakdown persists, the Fed might change how it conducts policy. It might even affect the fate of President Trump’s two controversial choices for the Federal Reserve Board — Stephen Moore and Herman Cain.

You may recall that Phillips refers to economist A.W. Phillips, whose 1958 landmark paper argued that there was a trade-off between unemployment and inflation: Lower unemployment generally produced higher inflation, and vice versa.

The logic seemed impeccable. Tight labor markets would raise wages, which would be passed along to consumers in higher prices. Phillips’ study of British wages and unemployment from 1861 to 1913 seemed to verify the relationship, which also seemed to hold for later decades. American economists found similar patterns in the United States.

The Phillips Curve was soon modified in one crucial respect. As economists Milton Friedman and Edmund Phelps pointed out, the effort to cut unemployment below a certain level wouldn’t just raise inflation. It would cause accelerating inflation — inflation that kept getting worse. Economists gave this level of unemployment various names: “full employment,” the “natural rate of unemployment” and the NAIRU (“the non-accelerating inflation rate of unemployment”).

Still, the basic logic remains relevant. As unemployment declined, upward pressures on wages and prices would intensify. This assumption is at the core of the Federal Reserve’s economic policymaking and is the main justification for raising interest rates when the economy improves. The Fed’s goal is to keep the economy growing without triggering higher inflation.

Although all this sounds cut-and-dried, it isn’t. In recent years, the economy has defied the Phillips Curve. As unemployment has dropped, wages and inflation haven’t risen sharply. In some ways, they’ve weakened.

Here’s an example. In 2010, unemployment averaged 9.6%, while average weekly earnings rose 3.3%, reports the Bureau of Labor Statistics. Inflation was 1.5%. By 2018, unemployment was down to 3.9%. But average weekly earnings of all nonsupervisory employees still grew only 3.3%, and inflation averaged 1.9%.

In their paper and blog post, Christopher Collins and Joseph Gagnon of the Peterson Institute find that “the relationship between inflation and unemployment has shifted.” But they don’t conclude that the change is permanent or irreversible. A continuing recovery could produce an unexpected rise in inflation, Gagnon said in an interview.

Just what explains the disconnect between joblessness and inflation isn’t clear. One theory is that the Fed has convinced most Americans that it will keep annual inflation close to its 2% target. Firms and workers feel comfortable with price and wage increases in this range, because they don’t fear being overtaken by higher inflation. Hence, many firms paid 2% wage increases even when unemployment was high.

Another possibility is that the severity of the Great Recession so frightened people that, again, they concentrated on keeping their jobs rather than pressing for a bit more pay. An older work force could have the same effect, as more middle-aged and elderly workers focus on job security. The threats to wages and prices posed by globalization would work similarly.

But these responses may be coming to an end. Indeed, some projections in the study suggest modest inflation increases in the next few years. Americans would be mistaken “to believe that a strong economy and low unemployment are no longer capable of generating inflation,” the Peterson study says.

What all this suggests is that the Phillips Curve will survive in some form. It seems unlikely that the state of unemployment will have no effect at all on inflation. The departures of inflation from experience may be temporary. For the Fed, there’s no shortage of questions begging for answers.

 

(c) 2019, The Washington Post Writers Group