The Phillips Cure and Unemployment

The Short-Run and Long-Run Relationship between Unemployment and Inflation
Introduction
Phillips observed a consistent inverse relationship between wage inflation and unemployment when he analyzed data from the UK spanning nearly a century from 1861 to 1957. The explanation Phillips gave was simple: the lower the unemployment rate, the more employers had to do to attract talent and raising wages was one of the primary ways to do just that (Wulwick, 1987). In a tight labor market, companies would race to quickly raise wages, and during periods of higher unemployment there would be less pressure to incentivize workers as the latter would consider themselves fortunate just to have a job. Since wages offered laborers are linked to prices businesses charge consumers (Lucas & Rapping, 1969), it was not long before economists applied the Phillips curve to inflation in general rather than to only wages. It became evident that monetary policy could be determined by using the Phillips curve as a model. One economist who objected, however, was Milton Friedman, who argued that employers and laborers only cared about the purchasing power of real wages, which would adjust so that supply and demand forces could operate in labor. The rate of unemployment, in other words, was not tied to inflation but rather to real wages. Friedman (1977) objected to the central bank’s idea that it could higher inflation for lower unemployment. By trying to manipulate the labor market below where the natural forces of supply and demand determine it should be, Friedman contended that the government/central bank would create a money illusion—the sense among laborers that they were getting paid more—but the reality would be that their money now had less purchasing power because of inflation. Friedman distinguished between the short-run and the long-run of the Phillips curve to make his point. This paper will show why Friedman was right to make his objection.
Short-Run vs. Long-Run
The difference between the short-run and the long-run with respect to the Phillips curve, as demonstrated by Friedman (1977) is that when the natural rate of inflation is generally constant, as it was during the 1960s, the inverse relationship between inflation and unemployment holds true. This is the short-run. However, when the central bank attempts to adjust the rate of inflation in order to lower the rate of unemployment, the long-run shows that unemployment will return to its natural rate following the labor market’s processing of price inflation caused by central bank intervention. The attempt to change a natural process (unemployment rate) through an artificial adjustment of a correlating variable in that process does not have a long-term effect on the natural process but does have a long-term effect on the inflation rate. Friedman (1977) showed in the 1970s that the sooner workers adjusted their expectations of price inflation, the less successful the government would be in applying its monetary policy to the problem of unemployment.
Friedman’s argument led to the creation of the expectations-augmented Phillips curve and the consensus opinion that at some point there can be found a stable rate of unemployment that is consistent with a stable rate of inflation; however, the data shows that the relationship tends to be more complicated in reality than in theory (Stiglitz, 1997). An assessment, analysis and evaluation of the 20-year U.S. unemployment and inflation data will show this complexity. The relationship between unemployment and inflation is different in the short-run (wherein inflation rises and unemployment drops) and the long-run (wherein inflation remains but unemployment returns to its natural rate) because of the money illusion factor in the short-run and the reality that eventually laborers realize the value of their real wages which causes unemployment to return to its natural rate.
20-Year U.S. Unemployment and Inflation Data
An assessment of the current 20-year U.S. unemployment and inflation data (1999 to 2019) does confirm the short-run Phillips curve. In 1999, unemployment stood at 4.0% and inflation was at 2.7%. In 2000, inflation rose 3.4% and unemployment dropped slightly to 3.9%. In 2001, inflation dropped to 1.6% and unemployment rose to 5.7% (Amadeo, 2019). Over the short-run, therefore, one can see a correlation between interest rate movement and unemployment rate movement. However, by 2002, things changed. Inflation rose to 2.4% and unemployment also rose to 6.0%. Inflation then fell back to 1.9% and unemployment also fell to 5.7% in 2003. Inflation then rose the next two years to 3.4% and unemployment trended downward to 4.9%. Inflation then fell in 2006 only to rise again in 2007 and unemployment mirrored the action and showed no inverse moves. In 2008, the Federal Reserve slashed rates heavily and inflation fell to 0.1% from 4.1% the year prior. Unemployment rose from 5.0% to 7.3%. Inflation rose to 2.7% in 2009 and unemployment also rose to 9.9% the same year. Only twice from that point on—in 2011 and in 2016—was there an inverse relationship between inflation and unemployment (Amadeo, 2019).
The long term FRED chart from the St. Louis Fed indicates the long-run picture more clearly. From 2003 onward, the 10-Year Breakeven Inflation Rate hovered around 2.5%, dropping sharply to near 0% in 2008 before rebounding the following year, tagging 2.5% again and trending downwards in a range between 1.6% and 2.11% from 2014 on. Unemployment however went from 4.6% when inflation was at near zero to 9.9% when it rose back to its prior norm at 2.5%. As the inflation rate has only modestly trended downward since then, the unemployment rate has fallen more dramatically and is now around 3.0% (FRED, 2019).
Analysis
The data confirms the short-run curve initially following the DotCom implosion in 2000—but as Friedman (1977) argued would happen the labor market eventually caught on to the impact the central bank was having and following the implementation of unconventional monetary policy—quantitative easing (QE)—beginning in 2008 and lasting until 2014 (Heller, 2017), the labor market only twice responded according to the theory put forward by Phillips—i.e., that manipulation of the inflation rate upwards or downwards would trigger an inverse reaction in the unemployment rate. As the data shows, this inverse relationship only occurred twice following the global economic crisis. The rest of the time, the short-run was non-existent. The long-run case argued by Friedman was much more evident.
The reason for this could be because, as Friedman noted, the natural rate of unemployment finds its level as workers adjust their sense of the value of their money over time. Adjusting the inflation rate over time has less and less effect. However, there were multiple forces at work over the 20 year period examined. First was the DotCom bubble popping in 2000. This was followed by the housing bubble bursting in 2008, the same year the Federal Reserve’s QE started. The lowering of interest rates and the buying of mortgage-backed securities along with U.S. Treasuries created an inflationary effect in equities markets and across asset classes from real estate to precious metals. Prices of services increased (health care, education, rent, etc.). The Trump Administration also focused on bringing jobs back to the U.S. by levying tariffs on other countries. From 2016 onward, that variable could also be a factor in the movement of unemployment downward. The complexity of the reasons for the downward trend in unemployment since 2008 (not to mention the manner in which unemployment is considered unemployment and whether the numbers reflect the reality) cannot be fully determined simply be using the Phillips curve.
Evaluation
Can the Phillips curve still validly resolve today’s issue of unemployment and inflation and forecast unemployment and inflation? The answer is no. Since 2008 and the implementation of unconventional monetary policy by the central bank, which, moreover, Fed Chair Powell recently indicated (along with Draghi at the ECB) that said policy is here to stay as a new normal tool, whatever relationship existed between inflation and unemployment has been skewed sharply by the promise of central bank intervention, “free money,” inflation, and the political cry for more socialist policies on the part of the government to counter the growing gap between the wealthy 1% and the rest of America’s workers.
Today, there are myriad factors that should be considered outside of the variable of the inflation rate. For example, what types of jobs are being created in the new and improved economy since 2008? Should an inflow into service sector employment and contract work really count as significantly as inflow into manufacturing? The problem of the economy in 2019 is not so much whether the central bank can influence the unemployment rate by adjusting the inflation rate; rather, the problem is rather the central bank has done too much intervening to the point where global markets are destabilized, corporations are over-leveraged, and the slightest trigger (or black swan event) could cause the confidence upon which the entire system is dependent to go out like air in a popped tire.
Recommendation
As a policy maker for monetary policy, the current U.S. unemployment and inflation rate model is an ineffective tool for the central bank to use. Indeed, the Federal Reserve has all but admitted that the only policy tool it has today that can have any impact on the market is QE. However, as bond yields are falling and an inversion between the short and long end has occurred indicating possibly a recession on the horizon, the central bank appears to be behind the curve: it has kept the Fed Funds Rate under control since 2008, raising it ever so slight at 25 bps at a time in order not to jolt markets and bring about the one event it wishes to forestall—i.e., recession. The problem is that corporations (and the government) have gotten used to low interest rates and all are leveraged beyond what would be normal or appropriate in times wherein rates are determined by the market rather than by the central bank. Inflation rising is now a given because of the promise of more QE, and the recent move in gold to six year highs (breaking above $1400 today) indicates that market is fully aware of the inflationary impact QE has.
What can the central bank do in terms of monetary policy? Attempting to control the inflation rate (which, like the unemployment rate, is also questionable as the use of hedonics raises issues of whether the inflation rate accurately reflects real price movement) is a non-starter at this point and the markets know it along with labor. Labor, however, is without many options (in spite of unemployment being low) because, as has been noted, many workers are joining the services industry (i.e., tips instead of salaries) or are no longer even actively looking for work (which removes them from the unemployment numbers). As more and more students come out of college deeply in debt and find that bartending or waitressing is a better option than taking a job in corporate America where there is no job security and few benefits, the true estimate of the skills they have learned at university may be becoming apparent. Regardless, the outlook for the Phillips curve is not positive. Its utility in terms of developing policy is no longer relevant: 2008 changed everything. Now the central bank’s only policy is to continue to inflate the asset bubble or risk bringing down the entire global financial system when confidence in that system evaporates.
Conclusion
By trying to intervene in the markets through the manipulation of inflation rates in order to reduce unemployment, the central bank creates an effect opposite of what it intends: it speeds along inflation while doing effectively nothing to alter the long-run course of unemployment. Only short-run alterations may occur but over time the labor market realizes that the purchasing power of its wages declines and the unemployment rate naturally adjusts as supply and demand evens out all else. Today, the Phillips curve has little relevancy as a tool for central banks, as there has been no statistically significant correlation between inflation rate movement and unemployment rate movement over the past 20 years or especially since 2008 when the central bank’s use of unconventional monetary policy created an upswing across asset classes and has correlated with a rise in the price of services across industries. What tool can the central bank use at this point to moderate unemployment? Its hope is in more QE—but it remains to be seen whether such hope is well or ill founded.
References
Amadeo, K. (2019). Unemployment rate by year since 1929 compared to inflation and GDP. Retrieved from https://www.thebalance.com/unemployment-rate-by-year-3305506
FRED. (2019). FRED Graph. Retrieved from https://fred.stlouisfed.org/series/LNU04000024#0
Friedman, M. (1977). Nobel lecture: inflation and unemployment. Journal of political economy, 85(3), 451-472.
Heller, R. (2017). Monetary mischief and the debt trap. Cato Journal, 37(2), 247-261.
Lucas, R. E., & Rapping, L. A. (1969). Price expectations and the Phillips curve. The American Economic Review, 59(3), 342-350.
Stiglitz, J. (1997). Reflections on the natural rate hypothesis. Journal of Economic Perspectives, 11(1), 3-10.
Wulwick, N. J. (1987). The Phillips curve: which? whose? to do what? how?. Southern Economic Journal, 834-857.