Inflation, Unemployment and the Phillips Curve

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Inflation, Unemployment and the Phillips Curve

In 1958, economist A.W. Phillips observed a century-long inverse relationship between wage rates and unemployment in the U.K.  In 1960, noted U.S. economists Samuelson and Solow took Phillips’ original idea and made the link between inflation and unemployment quite specific; that is, “when unemployment is low, inflation is high, and vice-versa.”  This idea became known as the Phillips Curve; the “curve” shows a strong relationship such that when the historical data are set out on a graph with one axis labeled unemployment and the other inflation, there is a close fit between low unemployment and high inflation, and vice-versa. Intuitively, this makes sense: in a stable world where economic growth is occurring but there are few people unemployed, wages rise rapidly as employers bid up the price of the scare labor resource.

This has been a fundamental guiding economic theory used by the Federal Reserve for decades to set interest rates.

But according to a new study by the Philadelphia Fed’s top-ranking economist the Phillips Curve Doesn’t Work!  Specifically, this fundamental principle at the heart of the Federal Reserve’s strategy for setting interest rates over the past three decades has, in fact, been found to be a poor guide for policy makers. 

The paper, co-authored by Philadelphia Fed Director of Research Michael Dotsey, shows that forecasting models based on the Phillips Curve, don’t help predict inflation.  Dotsey and Philadelphia Fed economists Shigeru Fujita and Tom Stark wrote, “Our results indicate that monetary policymakers should at best be very cautious in their reliance on the Phillips curve when gauging inflationary pressures,”

Their study is timely. Fed officials have been surprised by a deceleration in U.S. inflation over the past several months despite a continued decline in unemployment, the opposite of what the Phillips curve relationship would predict.

The Philadelphia Fed economists found that rising unemployment was sometimes able to help predict lower inflation, but falling unemployment didn’t help predict higher inflation. They noted that this was particularly the case during the 1970s and early 1980s when the Fed responded to runaway inflation by raising rates so high that the U.S. economy fell into recession...

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