Wednesday, June 8, 2022

The Phillips Curve


Behold the Phillips curve, one more statistical correlation treated as an eternal verity that our inflationary era has just undermined. 

From 2007 to 2019, the standard observation was "The Phillips curve has become flat." Large changes in unemployment correspond to very little change in inflation, or small changes in inflation correspond to huge changes in unemployment, depending on which causal (mis) reading of the correlation you choose. To the optimist, allowing a tiny bit of inflation could dramatically reduce unemployment. To the pessimist, it would take immense unemployment to do anything about inflation, should we have to.

Then came the pandemic. Unemployment shot up with no change in inflation, right on the curve. 

Then came the inflation. The Phillips curve woke up. It's almost vertical! (The scales of the two axes are different). 

Much Fed and commentator thinking relies on the Phillips curve. It's the central way interest rates affect inflation, in conventional thinking. High interest rates raise real interest rates lower aggregate demand cause unemployment which causes via the Phillips curve, lower inflation. 

Clearly, something is very wrong here. Maybe expectations shift. Maybe supply shocks do matter after all. Surely one should start with a serious dynamic Phillips curve, as most macro literature does. Maybe the Phillips curve is flexible up but sticky down, and the natural rate shifts around.  Maybe prices are sticky until they aren't. As Bob Lucas showed long ago, the slope of the Phillips curve depends on the volatility of inflation. Countries with volatile inflation get no output boost from additional inflation. Thousands of epicycles can be added, and this post is a bit of an invitation to do so. Or maybe the Phillips curve was just a correlation after all, hiding a deeper reality. (My view, but for another blog post). 

In the meantime, it's another good warning not to take statistical correlations too seriously, and certainly not as causally as we tend to do. Such as inflation will always be 2%. Such as real interest rates are on a permanent downward trend? 

This time of inflation will lead us to rewrite an awful lot of macroeconomics. 


16 comments:

  1. I wasn't alive in the 1970's, but it certainly was a seminal period in economic history. What we have now looks an awful lot like the 1970s, with a lot of the same ex post explanations being offered about why inflation is so high.

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  2. Of course the Phillips curve is flat when somebody makes inflation constant at x % per year. Changes in unemployment would be exclusively due to supply shocks.

    Then comes COVID -- unexpected, though temporary, overall negative supply shock + [huge] overall positive demand shock, bigger than expected, I think, and yup, inflation rises.

    The only surprise in the data to me is how quickly expectations adjusted - near vertical is near vertical.

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    1. How did I get to be anonymous? I'm Frank.

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  3. I'd say the general lesson is that you should be deeply suspicious of "new" theories that happen to correspond with what you desire to be true.

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  4. The bottom one-third to one-half of the labor force is experiencing the best job markets in more than 50 years. PCE core near 5% and cooling off.

    Orthodox macroeconomists are in hysterics over the present rate of inflation, but perhaps 50 million to 80 million Americans are enjoying better prospects in the workforce.

    I wonder if a 5% rate of inflation is a reasonable exchange for tight labor markets.

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    1. Apparently not tight enough.

      https://fred.stlouisfed.org/series/LNS12300012

      32% employment to population ratio now compared to the high 40-45% range from 1980-2000.

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  6. Have you read the Fiat Standard? Seems much of modern monetary theory was made up to justify government policy.

    Shortages have little to do with price changes beyond suppliers not adjusting the price fast enough. Simlarly, unemployment has little to do with price changes. The real cause of the phillips curve is poverty: people work more when they are poor. Inflation leads to poverty, which leads people to work more.

    In COVID times we saw this clearly: when people were flush with government cash, we saw the great resignation. As the money runs out, we'll see more people looking for jobs. Whether they find them or not is a function of labor-suppliers (aka: employees) lowering their prices fast enough.

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  7. I took economics in the mid 70s and there was talk that the Phillips curve "shifted" to try to explain why things didn't fit.

    But a more fundamental question is whether the Phillips curve even exists outside a few cherry picked periods? I've looked at inflation / unemployment graphs in the past and seen a lot of random scatter plots having little resemblance to a curve.

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  8. "This time of inflation will lead us to rewrite an awful lot of macroeconomics."

    Start with this - page #1 - Interest is often construed to be the cost of borrowing. This is technically not accurate. Interest is the cost of time associated with any non-simultaneous transaction.

    For instance, if I may be willing to pay you $20,000 for a car delivered to you today, but only $18,000 for the same car delivered to me a year from now. Effectively I am charging you interest on the money I am giving to you now for a car to be delivered at a later point.

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    1. Page #2 - The most efficient political economy is an autocracy - the king determines how much "stuff" each individual gets. All trades have a 100% success rate.

      The 2nd most efficient political economy utilizes three party trading. All trades have a 50% success rate.

      The 3rd most efficient political economy utilizes two party trading (what we have now). All trades have a 25% success rate.

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    1. So the replacement is what?

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    3. After Keynesian Macroeconomics - Thomas Sargent & Robert Lucas

      "Should this intellectual arbitrage prove successful, it will suggest important changes in the way we think about policy. Most fundamentally, it will focus attention on the need to think of policy as the choice of stable rules of the game, well understood by eco- nomic agents. Only in such a setting will economic theory help predict the actions agents will choose to take. This approach will also suggest that policies which affect behavior mainly because their consequences cannot be correctly diagnosed, such as monetary instability and deficit financing, have the capacity only to disrupt. The deliberate provision of misinformation cannot be used in a systematic way to improve the economic environment."

      To get to stable monetary policy rules of the game, you also need stable fiscal policy rules of the game such that the two are never at loggerheads.

      One method is fiscal neutrality / surplus (government does not borrow or print money).

      Another is equity sold by government Treasury (government does not borrow or print money).

      In both cases, monetary policy focused solely on price stability is achieved.


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