Does Philips curve help in recessions?

Zheng Liu and Glenn Rudebusch of San Frasisco Fed have a nice short paper on this topic.

The never ending debate on Philips curve:

Since the fourth quarter of 2007, inflation has declined substantially. During the same period, the unemployment rate has more than doubled. Are these two developments connected?

The well-known Phillips curve model suggests that that the high level of unemployment and pervasive slack in the economy could contribute to the decline in inflation. Many economists argue that the Phillips curve relationship between unemployment and inflation is a key part of the linkage between the monetary policy instrument–the short-term interest rate–and the monetary policy objective of price stability (Rudebusch and Svensson 1999). However, Phillips curve skeptics maintain that there is little empirical evidence of a relationship between economic slack and inflation. For example, Atkeson and Ohanian (2001) find that, from 1984 to 1999, Phillips curve forecasts are no better than naive forecasts that assume inflation will not change, that is that it will be the same over the next year as it has been over the past year.

The paper shows how Philips curve can actually be useful in recessions. The persistent low unemployment rates in future should lead to a lower inflation as well.

This Economic Letter examines recent evidence concerning the connection between unemployment and inflation. We argue that, in a deep economic downturn such as the current one, inflation and unemployment do tend to move together in a manner consistent with the Phillips curve. But, outside of such severe recessions, fluctuations in the inflation and unemployment rates do not line up particularly well. Inflation appears to be buffeted by many other factors. This explains why some studies find only a “loose empirical relationship” between economic slack and inflation. Thus, compared with the relatively tranquil period between the mid-1980s and the mid-2000s, evidence suggests that recent high unemployment rates are broadly consistent with the sizable decline in core inflation since the fourth quarter of 2007, a relationship that broadly fits the Phillips curve model.

Read the paper for the analysis. Very simply explained.

However, the authors add caution:

Our statistical evidence should be interpreted with some caution. Our evidence does not imply that inflation cannot run up as long as unemployment remains low. Other factors determine inflation beside the unemployment gap. This is an important and painful lesson that we have learned from the experience of the 1970s. For example, supply shocks and commodity price increases can push inflation up. Furthermore, inflation expectations are also likely to be an important inflation driver and are incorporated in modern Phillips curve theories.

But it does not follow that inflation expectations cannot run up. So far, inflation expectations have likely remained stable despite the unprecedented expansion of the size of the Federal Reserve balance sheet mainly because the Fed has clearly communicated its commitment to price stability and, more importantly, market participants view this commitment as credible. To keep inflation expectations under control, it is essential to maintain the Fed’s credibility and the independence of monetary policy from politics.

This is pretty timely as well. UK inflation for December surged to 2.9% from1.9% in November . Though much of it is because of base effect and is just a one time number but was much higher than expectations. Inflation expectations are supposed to be forward looking but research shows much of it is based on current trend as well. So, there is always an issue of causation between inflation and inflation expectations. If UK high inflation trend persists (for whatever reasons), inflation expectations would shift upwards as well. 

Coming back to Philips curve. It would be interesting to look at more historical evidence and see the relationship in other recessions in other countries as well. It could be an important insight.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.


%d bloggers like this: