Who Killed the Phillips Curve?

As central banks around the world continue to tighten monetary policy in an effort to tame inflation, the question on everyone’s mind is if monetary policy will be able to slay the inflationary dragon without plunging the economy into a recession. Rhetoric from the Federal Reserve (Fed) would suggest that monetary policymakers have come to terms with the potential for creating an economic recession, declaring that the greater risk is allowing inflation to become entrenched. While the Fed may be right that entrenched inflation is indeed dangerous for the economy in the long term, one could argue that the blunt instrument of monetary policy may be too ham-fisted to be successful in tackling the complex issue of inflation. For an economy that is dealing with twin inflationary drivers (demand-pull via fiscal stimulus and cost-push via supply chain shocks), it is obvious that adjusting monetary policy won’t be able to solve the supply shock issues that have led to the inflation. Higher interest rates won’t be able to solve extreme weather events affecting crop production or aid Europe in finding reasonably priced alternatives to Russian natural gas. However, will monetary policy even be successful at influencing demand-pull inflation, as we harken back to the 1980s and envision when then Fed Chair Paul Volcker crushed inflation by aggressively rising interest rates to a peak of 20%? A lesser know fact is that during this period where Volcker was perceived as successfully fighting inflation, the Fed created massive interest rate volatility by reducing interest rates from 20% to 10% in the early 1980s, before reversing course and raising rates back to 20% less than a year later. Had it not been for Volcker and the Fed bumbling interest rate policy in the 1980s, the consequences of which led to a dramatic tightening cycle in a short period of time, we would currently be experiencing the fastest tightening cycle by the Fed on record. In this context, did Volcker’s direction of monetary policy stamp out inflation, or were there other catalysts at play, with the associated interest rate volatility doing more harm than good?

As Powell and the Fed brace the labour market for pain as interest rate hikes work their way through the economy, this article from Vox examines the Phillips curve and whether the Fed’s policy of focusing on bludgeoning the labour market will result in a successful victory against inflation. The Phillips curve is an economic theory from the late 1950s, which posits that as unemployment falls, inflation rises. A simplified version of the theory being that as the economy grows and labour becomes scarce, wages are pushed higher which effects broad prices in the economy, leading to higher inflation. Therefore, in order to stop inflation from becoming entrenched, the focus of the Fed is to increase interest rates to slow economic growth and increase unemployment. There has been much debate over the last decade on if the Phillips curve was broken, as during the recovery period after the Financial Crisis of 2008, the unemployment rate continued to plumb new lows (up until the COVID lockdown) without any upward pressure on inflation. While puzzling as to why the Phillips curve may have died, one theory was that the credibility of global central banks had improved such that expectations of future inflation were grounded by the fact that central banks would intervene with interest rates before inflation became entrenched. Now with inflation untethered from the Fed’s long-term target and in danger of becoming entrenched, the Fed seems keen to revive the Phillips curve from the dead in the hope that inflicting pain on the labour market will help ease inflationary pressures.

An academic paper released earlier this year explores the Phillips curve and provides an additional explanation on the death of the economic theory. The authors of the paper posit that labour market policies that eroded worker bargaining power were behind the murdering of the Phillips curve, showing that a “nearly 90 percent reduction in inflation volatility is possible even without any changes in monetary policy when the economy transitions from equal shares of power between workers and firms to a new balance in which firms dominate.” This would square with the argument of some post-Keynesian economists that the disinflationary thrust experienced over the last two or three decades (prior to the COVID lockdown) was more attributable to globalization increasing labour competition and the demise of union bargaining power. However, with globalization facing serious headwinds, some of the catalysts influencing the secular disinflationary trends of the last two decades are waning.

In the absence of more nimble fiscal policy and regulation to tackle some of the thorny issues leading to inflation, the reliance on ham-fisted monetary policy to “go-it-alone” may have individuals questioning whether the juice ends up being worth the squeeze. Given the praise current Fed Chair Powell has heaped on Volcker, it seems unlikely the economy won’t experience an overcorrection in monetary policy tightening, along with the fact that the Fed has already lost credibility with their “transitory” call on inflation earlier in the cycle. While we may be witnessing another monetary policy mistake of the same magnitude of Volcker era, with the Fed facing both internal and external constraints like it is, they may have no choice but to continue on their current course. We don’t have crystal balls here at Viewpoint, but we would caution whether investors are going to be well served by putting blind faith in a Fed pivot in the short term. Instead of focusing on equity-centric ways of expressing an investment thesis on a Fed pivot, having a balance of risk premia will aid in increasing portfolio resiliency during these uncertain economic times. It seems like this would be a good place to quote Mark Twain, who said, “history doesn’t repeat itself, but it often rhymes.”