That central banks cannot endlessly reduce unemployment without sparking inflation is economic gospel. It follows from “a substantial body of theory, informed by considerable historical evidence”, according to Janet Yellen, chair of the Federal Reserve. Her conviction explains why, on June 14th, the Fed raised interest rates by a quarter of a percentage point, to a range of 1-1.25%.
Here’s what Yellen, no longer Fed chair, said on Tuesday at an event put together by Bruegel, a Brussels-based think tank:
Unemployment may need to…. stay at very low levels for a very long time for inflation to rise to not just two, but over two, per cent.
And here’s current Fed chair Jay Powell on the same topic last week (with our emphasis, here and elsewhere):
The historically strong labour market did not trigger a significant rise in inflation. Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realized on a sustained basis. Inflation forecasts are typically predicated on estimates of the natural rate of unemployment, or “u-star,” and of how much upward pressure on inflation arises when the unemployment rate falls relative to u-star. As the unemployment rate moved lower and inflation remained muted, estimates of u-star were revised down. For example, the median estimate from FOMC participants declined from 5.5 percent in 2012 to 4.1 percent at present.
Gospel no more.
The long-held view that you cannot have a tight labour market without wage growth outstripping productivity growth — inflating prices in the process — is often expressed by the Phillips Curve. Here’s what it is supposed to look like (images via voxeu.org):
The reality is somewhat messier, with many countries mirroring this French example where their curve has become pretty much flat in recent years:
The Phillips Curve matters because it feeds into policymaking, leading central bankers, for instance, to prematurely hike rates in the expectation that inflation will soon surge on the back of the labour market’s strength.
Indeed another Fed policymaker Lael Brainard has acknowledged that the rate hikes the central bank made in the years leading up to the pandemic were missteps. The abandonment of the curve has helped drive Powell’s view that it should shoot for an average inflation rate of 2 per cent, rather than targeting a rate of 2 per cent in the medium term regardless of whether prices were lower in the preceding years.
What that means in terms of monetary policy in the years ahead is that rates will stay lower for longer, even if unemployment falls back to where it was pre-pandemic. From Brainard’s speech:
The longstanding presumption that accommodation should be reduced preemptively when the unemployment rate nears the neutral rate in anticipation of high inflation that is unlikely to materialize risks an unwarranted loss of opportunity for many Americans. The decision to allow the labor market to continue healing after the unemployment rate effectively reached the 5 percent median Summary of Economic Projections (SEP) estimate of the normal unemployment rate in the fourth quarter of 2015 supported a further decrease of 3-1/2 percentage points in the Black unemployment rate and of 2-1/4 percentage points in the Hispanic unemployment rate, as well as an increase of nearly 3 percentage points in the labor force participation rate of prime-age women. It also created conditions for the entry of a further 3-1/2 million prime-age Americans into the labor force, a movement of nearly 1 million people out of long-term unemployment, and opportunities for 2 million involuntary part-time workers to secure full-time jobs.7 Beyond that, had the changes to monetary policy goals and strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the gains would have been greater.
A big reason why the Phillips Curve is so flat is that wage growth has been weak. That tells us that the relationship between the labour market and inflation is not solely about the unemployment rate, but about labour’s bargaining power too. It doesn’t take an economist to see, whether its in the gig economy or at larger firms, that employee bargaining power is far weaker than it was in the late 1950s – when the curve was created – and the decades that followed. During this period higher price pressures, sparked in part by the 1973 oil crisis, fed into higher wage demands creating a vicious spiral that resulted in years of double digit inflation.
One can question why it took so long for the Fed, and other central banks, to realise this spiral was no longer such a threat. A bigger issue going forward might be that, if low unemployment no longer leads to inflation, then what does?