What Phillips curve?

Economists have recently been abandoning once-core concepts in macroeconomics such as the money multiplier and IS-LM model. This week's figures remind me of something I'd also throw on the bonfire - the Phillips curve.

My chart shows the point. It shows that the relationship between the official measure of unemployment and CPI inflation four quarters later has been perverse. Higher unemployment has led to higher inflation, not lower as the Phillips curve says.

If we control for inflation expectations, as surveyed by the Bank of England, this perverse relationship weakens - but there remains a statistically significant positive relationship between lagged unemployment and inflation.

One reason for this might be that the official measure of unemployment is inadequate. It excludes the 2.3 million of "economically inactive" people who'd like a job and the 1.3 million of part-timers who want a full-time job.

If we take this wide measure and control for inflation expectations, we do get a negative relationship between unemployment and CPI inflation. But it is not statistically significant (p value = 25.7% for quarterly data since 1999Q4). Nor is it economically so; a one million drop in the wide measure of joblessness is associated with only a 0.16 percentage point rise in CPI inflation.

I'd suggest three reasons for this weak relationship. It's because the tendency for a tight labour market to raise wage and price inflation is offset by three other mechanisms:

One is globalization. In a small open economy, inflation depends upon inflation overseas and the exchange rate. Euro area deflation and the strong pound in recent months have offset falling unemployment. As one of the better macro textbooks says:     

In an open economy, there is a range of unemployment rates consistent with the absence of inflationary pressure. (Carlin and Soskice, p343)

Secondly, fluctuations in aggregate demand aren't the only story. Supply shocks such as commodity price moves or changes in productivity growth can generate positive correlations between unemployment and inflation.

Thirdly, inflation isn't necessarily cyclical. In a classic paper in 1986, Julio Rotemberg and Garth Saloner pointed out that price wars were more likely (pdf) in booms than slumps. The fact that supermarkets are cutting prices now is consistent with this.

Now, all this said, I'll concede that the conventional Phillips curve might exist outside the UK - though even in the US it is rather flat. For practical purposes, however, unemployment tells us very little about future inflation.

Comments

[Luis Enrique]

will you just stop it with the money multiplier? economists abandoned the idea that central banks could control the broad money supply by varying the size of their balance sheet (quant of base money) many many years ago - remember Thatcher's experiments with that? *. Meanwhile the idea that the quantity of broad money is some multiple of the quantity of base money thanks to the process of private credit creation has not been abandoned because it is true. The only bit that seems to have been believed in some quarters which needs killing off is the idea that banks need deposits BEFORE then can lend, but that's a mere detail and of course banks do fund lending with deposits ex-post.

* okay you can still find badly written text books

[Luis Enrique]

a more constructive response:

why not see the idea that labour market tightness has something to do with wage inflation and hence price inflation as one mechanism, in line with your previous writing? Inflation may happen for other reasons too, some of which you describe in these posts, and you may well ask why mainstream macro neglects other potential mechanisms. But seen that way, you would not expect to see a neat correlation between unemployment and inflation leap out of the data* as different mechanisms switch on and off and muddy the waters. That way, you wouldn't be suggesting the Phillips curve ought to be consigned to the trash heap because you don't see a neat correlation.

(another quibble is that some of the things you write about here are not inflation per se by changes in relative prices, which show up in inflation data which does not do a very good job of distinguishing between the two, there is an excellent paper on this which I now forget)

* I don't think you would anyway, curves being things that shift, but that's another point

[chris]

@ Luis - yes, I think you're right. My first par was a little over the top.
One poss is that the relationship looks weak in the data because of supply shocks, which are hard to quantify, identify and thus control for. It might therefore be sensible to set monetary policy on the assumption that there is a proper Phillips curve.
(Incidentally, how large is this set of ideas - that it's sensible to act upon ideas for which the empirical evidence isn't overwhelmig?)
However, the possibility that the curve is quite flat is surely a strong one, being consistent with both the data & open economy theory.
And I stopped it with the money multiplier years ago.

[Magnus Carlsen]

Great - a negative trade-off between inflation and unemployment. This should kill off any move to increase interest rates. Indeed, ever.

[Luis Enrique]

That's a great question, and one very relevant to my day job about the wisdom of continuing foreign aid in the absence of convincing empirical evidence. Where, I should say, the prospect of finding empirical evidenced is what Angrist calls FUQ'd a fundamentally unidentified question

[Jack Flattery]

Inadequate measuring of unemployment mentioned. What about mis-measuring Inflation possibility?

[Neil Wilson]

The idea that needs consigning to history is taking the viewpoint of a single nation

There is one world with a set of interacting currency areas.

[Neil Wilson]

"but that's a mere detail and of course banks do fund lending with deposits ex-post."

It's a bit more than a mere detail. It is fundamental to the reason why the economy tends to bubble.

On a daily basis it tends to inflate before deflating, which means that debt dynamically has an aggregate effect.

Banks lend and back fill *asynchronously* via a buffer based around a price. Lending takes a long time and people's expectations of being able to spend are solidified and often enacted via credit terms long before the loan is advanced.

Saving however takes zero time. It is the default option when you get paid.

[Jim]

What are the other better textbooks?

[ignoramus]

What about:

Will the Real Phillips Curve Please Stand Up?
http://www.hussmanfunds.com/wmc/wmc110404.htm

Real wage inflation (and not CPI) vs. unemployment

[Andrew]

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