The traditional workhorse among policymakers attempting to estimate the tradeoff between employment and inflation has been the Phillips curve.
During the past few decades, as the economy has shifted from one based on manufacturing to one based on information and digital technologies, this traditionally inverse relationship as shown in the Phillips curve has flattened.
The traditionally inverse relationship between unemployment and inflation as shown in the Phillips curve has flattened.
This implies that policymakers have greater freedom in setting interest rates and implementing fiscal policies to address the needs of the economy.
As the economy has shifted, we think that policymakers have gained greater flexibility to let the economy run hot without inflation expectations becoming unanchored while letting the unemployment rate fall toward our estimate of full employment, which stands at or below 3.5%.
For this reason, the Federal Reserve last year announced its flexible average inflation targeting regime in which a decline in the unemployment rate by itself will not be sufficient to trigger an increase in rates or other forms of tighter monetary policy. There will need to be other evidence that inflation is at risk of moving above mandated levels consistent with price stability.
The long-held tenets that guided decisions around monetary policy, standard Phillips curve models and the tradeoff between inflation and unemployment have been deemphasized.
The Phillips curve, explained
In the absence of restraints, we would expect hourly earnings to rise when the supply of labor decreases. As the economy expands and unemployment decreases, employers find themselves competing within a shrinking pool of labor by offering higher wages.
Conversely, when economic growth is slowing and employers begin to shed labor, the pool of labor increases and workers become willing to accept lower wages offered by employers in a take-it-or-leave-it climate.
This relationship generally holds over time, but there have been periods when other factors came into play. The most recent example of the breakdown came after the 2008-09 Great Recession. Though unemployment began to decline in the middle of 2010, the decline in wages continued until the end of 2012, most likely because of the loss of jobs in the manufacturing sector and the rise of employment in the lower-paying service sector.
Another example is the sharp increase in average wages paid during the widespread furloughing of workers during the economic shutdown last year. Employers reduced staffs, keeping only their most productive and highest-paid workers.
This simple supply-demand relationship can be seen in a scattergram of monthly unemployment rates and the yearly growth rate of hourly earnings, which is known as the Phillips curve.
In the first figure, we show the yearly earnings growth and unemployment rates between 1988 and 2002. During this period, the remnants of the manufacturing-based economy that had dominated the postwar economy were still around. As unemployment increased, wage growth diminished from about 4.25% per year but remained above or around 2.5% per year.
In the second figure, we show the same relationship in the pre-pandemic era from 2012 to 2020. In this era, higher-paying manufacturing jobs had given way to service-sector employment and lower wages.
Notice that the wage growth is predominantly lower than 2.5% per year and that the range of unemployment rates is slightly wider in this period than in the 1988-2002 period. As such, the more recent Phillips curve is flatter because of lower wages and compressed wage growth even when unemployment is extremely low.
This lack of responsiveness to a tightening market has been a concern for the monetary authorities and their ability to stimulate growth without a fiscal partner.
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