We revisit the Phillips curve—which shows the relationship between inflation and the unemployment rate.
The Phillips curve trade-offNamed after the economist A.W. Phillips, the Phillips curve has become one of the most important cornerstones of modern macroeconomics. In his seminal paper published in 1958, Phillips pointed out the inverse relationship between unemployment and wage growth. Since then, the curve has been extended and then augmented to show the short-term relationship between unemployment and inflation with major contributions from two Nobel laureates in economics, Edmund Phelps and Milton Friedman, in the 1960s. The intuition behind the trade-off between unemployment and inflation is that when unemployment is low, wage income is higher, which fuels more spending demand in the short run. Given the stickiness of supply in the short run, an increase in demand will push prices higher, causing inflation to rise. The opposite is also true: High unemployment leads to lower inflation. But in recent years, and especially during the pandemic, the Phillips curve relationship has become less clear, adding to the reasons why both market participants and the Fed’s inflation forecasts were so wrong. In hindsight, the primary explanation for the Fed’s failure to stay in front of the curve regarding inflation is the unique pandemic-related supply-chain disruptions, which have been anything but transitory. Given that explanation, we revisit the Phillips curve to identify the level of unemployment that would be needed to bring inflation back down to the long-term target, but with an important twist: adding a proxy variable for supply-chain deficiencies using data from our proprietary RSM US Supply Chain Index. Our supply-augmented Phillips curve includes five variables:
- Inflation expectations measured by the Fed’s Index of Common Inflation Expectations.
- The unemployment rate.
- The Congressional Budget Office’s natural rate of unemployment estimates.
- The RSM US Supply Chain Index.
- The inflation rate base on the personal consumption expenditures price index.