The Phillips Curve Debate

As I wade into the Phillips curve debate, a voice in the back of my brain is saying, no. It is reminding me of a great couplet in a fantastic Bengali dystopian fantasy movie, Hirok Rajar Deshe (in the land of the diamond king), "The quest for knowledge is endless, (hence) the pursuit of knowledge is futile." Still, I persist.

Let us take stock of the main questions:

1. Is there a stable relationship between inflation and unemployment, as the Phillips Curve has been defined in recent times?

2. Is there a stable relationship between unemployment and wages, the original Phillips Curve? 

3. Do wages cause inflation? 

4. Ultimately, does unemployment cause inflation?

I am a firm believer in Jon Elster's dictum that explanation in social sciences means the identification of causal mechanisms. Inflation is caused by an increase in money supply is NOT such an explanation. Derivative ones of the idea such as the following: an increase in monetary base leads price setters to expect inflation and therefore set prices higher is also a useless mechanism. Have you ever come across a businessman that follows the monetary base and sets prices? The notion that money translates directly into inflation was dubbed Immaculate Inflation by Karl Smith.

The following schematic represents the basic mechanism I have in mind, and I hope to show some evidence for it:

Here is a summary of my views:

1. There is no stable Phillips Curve. There is a much better case for a wage Phillips curve than for a price Phillips curve.

2. The causality from unemployment to inflation runs through wages.

3. The relationship between unemployment and wages is nonlinear, context-dependent, and contingent on history and institutions. 

4. There is a positive feedback loop between wages and prices, but the strength of that loop is also context dependent.

5. Yes, central banks have the power to interfere with these causal processes, but they are not omnipotent as Monetarists assume. Central banks face a trilemma: there is an inherent conflict in maintaining low unemployment, stable inflation, and financial stability (see my posts). The early postwar decades were an exception.

Let us start with wages and unemployment. Outside of coercive arrangements, is it outlandish to suggest that low unemployment will tend to drive wages higher? Of course, the context matters--the degree of unionization, the implicit compact between firms and workers (see for instance the excellent book The End of Loyalty), the degree of monopsony in labor markets, etc. Moreover, the unemployment rate might not be a good indicator of the slack in the labor market, as we have seen for much of this cycle. That said, in a fairly competitive, capitalist economy, the smaller the pool of available workers, the more difficult employers will find to fill open positions. More important, employers are likely to pay up to retain workers who may be lured away. Let us look at the evidence. The following is an excellent chart from a Cleveland Fed report:  

As the chart shows, labor market slack has a stronger correlation with wages than with prices. In both cases, labor market slack leads--the correlations are much stronger when k is negative in the graph. To be sure, correlations have weakened in the post-1984 era. As I said, institutional context matters. Not only has unionization declined but also we have had extended periods of labor market slack in this era. As the chart below shows, the unemployment rate has been higher than the CBO's estimate of NAIRU for much of the post-1984 period.

Having shown some evidence for the first link, let us now turn to the wage-price link. In this case, there is a positive feedback loop: higher wages lead to higher prices, which in turn lead to demands for higher wages. Again, the context matters: for example the presence of institutional arrangements, such as cost-of-living-adjustments (indexation of wages to prices). Here is a chart that shows the employment cost index (ECI) against CPI services. I have used CPI-services ex-energy to isolate the prices of domestic nontradebles. In the tradeble sector, the ability of domestic producers to pass on cost increases will be constrained by competition from imports, especially in the era of global glut. Even a casual look at the chart shows that ECI leads CPI. I ran a crude two-way Granger causality test and the results reject the null hypothesis of no causality from wages to prices.

The Cleveland Fed paper, which runs the relationship between various wage measures and PCE, observes: "Our measures have been moderately positively correlated since 1960: both price inflation and wage inflation tend to be above (or below) trend at the same time (figure 2). The strongest correlations have been between core PCE inflation and the ECI. The weakest correlations have been with the CPH measure, which is not surprising given its volatility. Depending on the measure, wages either lead core PCE inflation very slightly or are contemporaneous with it: the correlation peaks come in quarter t+1 or t." They also note that the correlations have been weaker since 1980, which is to be expected given that there is widespread overcapacity in the domestic economy even outside the tradeable sector.

The usual Monetarist response is that the feedback loop between wages and prices would never get started unless the Fed accommodated the process by allowing money supply to increase. True, but the only way to curb the feedback loop is to weaken the real economy and the labor market. Immaculate control of inflation does not exist. Yes, expectations do matter, but more likely in the context of high inflation. At low levels of inflation, the expectations fairy is just that.

The bottom line: there may not be any stable Phillips curve but to infer that there is no relationship between labor market slack and inflation is not warranted.

Monetary Policy Feedback Loops and Instability

Inspired by this post by Edward Harrison, I sketched the diagram below to show the various feedback loops operating in the economy.  Red arrows are positive feedback loops (destabilizing) and blue arrows are negative feedback loops (stabilizing), By no means is this a comprehensive rendering of all interactions in the economy, but it is good enough to illustrate monetary policy dynamics, the inherent instability of a system, and that a single interest rate that stabilizes the system is unlikely to exist.

Start with the bottom loop, which we can call the conventional view of the real economy. Economic activity picks up, slack diminishes, inflation rises, and the Fed hikes rates, which, in turn, increases the cost of the capital and debt-service costs and slows the economy. In this Wicksellian world of New Keynesian economics, there exists a single rate, the natural rate, that delivers stable economy growth with steady inflation. 

Let us bring in credit. There is a positive feedback loop between credit and the economy. Greater availability of credit boosts the economy, and increased economic activity, in turn, supports debt-service and validates the credit decisions. The central bank usually does not interfere with the credit channel directly. In crises, central banks step in directly to provide liquidity to the credit markets. In theory, they have macroprudential tools to directly control credit markets. In practice, monetary policy assumes that the interest rate that stabilizes economic activity also stabilizes credit via debt service.

Finally, include the asset side of the economy. Now, there are three positive feedback loops: 1) between the real economy and credit, 2) between credit and asset prices, and 3) between asset prices and the real economy. There are two negative feedback loops--but the second one between monetary policy and asset prices is not directly operative to the extent the Fed eschews "targeting asset prices." So, essentially there is one negative feedback loop to stabilize the economy against three potentially destabilizing dynamics. In the perfect world of rational expectations and common knowledge, this is not a problem. If financial market participants bid up asset prices, Tobin's Q would go up. Firms would be incentivized to invest, which would then strengthen the economy, leading to higher interest rates and lower asset prices. 

However, in the real world, the expectations of financial market participants can diverge from the expectations of business executives making capital spending decisions. So, if financial market participants take a rosier view of the future, they can bid up asset prices, but, to the extent business capital spending decisions are driven less by cost of capital and more by demand, business executives may see limited opportunity for fixed investment. In that case, the economy may remain tepid, the Fed will remain accommodative, supporting the asset price speculation. Moreover, to the extent the real economy has considerable slack, the Fed has the freedom to address financial market turmoil, or the Fed Put is closer to the money. In some ways, this describes the situation of the past several years. On the other hand, if the real economy is booming and/or inflation is high, the Fed, driven by real economy considerations, may be constrained in its willingness to pay obeisance to every market hiccup. The Fed Put would be further out of the money. For instance, in 2000, as the Nasdaq was plunging, the tight labor market prevented the Fed from cutting aggressively until it was too late. One could say the same in 2007--home prices were falling and the positive feedback loops from home prices to housing credit were beginning to look ominous--but inflation and still low unemployment prevented the Fed from aggressively cutting rates to resuscitate the housing market.            

Suppose the system were somehow stable. Minskian meta-dynamics throws wrench. If the system is stable, then some participants on the margin will be encouraged to take a little bit more risk by extending credit to more risky borrowers, bidding up asset prices, and raising the credit-to-GDP ratio. The increased flow of credit will boost economic activity, forcing the Fed to tighten. However, note that the Wicksellian rate may now be too high to stabilize debt-service and the economy. When faced with rising inflation and increasing financial stresses, CBs have two choices, ignore inflation and focus on credit market stability or tackle inflation and allow a recession to occur. The idea that they can thread the needle--find a rate that delivers stable inflation and stable credit--is implausible in a Minskian world, unless there is heavy-handed and continuously evolving regulatory suasion (see this). Minsky in his own words: 

Consider three separate episodes in U.S. history. First, 1966-67. Core inflation had surged from a sub-2% level in early 1966 to over 3.5% by late 1966. The economy was slowing but not enough to arrest labor market pressure. However, a severe credit crunch was developing. The Fed had two choices (I am grossly simplifying): ease policy to address the credit crunch or focus on inflation. The Fed eased, a recession was averted but inflation kept climbing thanks to which two people won Nobel prizes (one very, very undeserving in my opinion), and due to which the economics profession became madly obsessed with inflation. 

Now consider 1990. The Fed had started easing in 1989 as bank and S&L failures were soaring and the economy was clearly weakening. But in early 1990, surging inflation stayed the Fed's hand despite growing financial stresses. Eventually, the Fed eased in the second half of 1990, but the economy was already in recession. In hindsight the inflation threat was a headfake, or was it? If the Fed had arrested banking sector problems, then credit flow would have not stopped, the economy would not have weakened, and in the absence of the magic expectations fairy, inflation likely would not have come down. 

Let us now fast forward to 2008. Those who were "hawks" on the FOMC back then are being roasted right now on the 10th anniversary of the crisis. But consider the situation in mid June 2008 (not after Lehman had collapsed). Retail sales had rebounded strongly, ISMs were hovering near 50, real GDP growth had bounced back in the second quarter, and the global economy was solid. Not everything was fine--payroll decline was worsening for instance. Meanwhile, core inflation was accelerating and oil was skyrocketing toward $150. While financial stresses remained, the Fed had successfully engineered the absorption of Bear Stearns by JP Morgan and Countrywide by Bank of America, and the VIX, the TED-spread, and high-yield spreads had all declined.The Fed had already cut rates by 325 bps. So, is it such a blunder that the hawks resisted further easing in June-July? Without the advantage of hindsight, what makes easing of 1967 a blunder and not easing of 2008 a blunder too? Yet, monetarists in particular hold on to both views.

There was likely no right path: easing would have validated the hawks and not easing further validated the doves. As it were, the second path was chosen and the doves seem prescient, but like Schrodinger's cat, both views were right ex ante, but the whichever view was followed would have been proved to be wrong ex post!  

(Let me be clear: my colleagues at the Levy Forecasting Center were expecting and betting on a deflationary collapse. Yet, we had the advantage of a financial-oriented systems dynamics view of the economy. The Fed was arguing from models of the real economy where balance sheets were an epiphenomenon.)

Many would consider the Fed's actions in 1990 and 2001 as successful instances of threading the needle in contrast to its policymaking in the 1960s and 1970s or 2008. Yet, the recessions of 1990-91 and 2001 had long-lasting effects. Matt Klein had an excellent piece on the early 1990s. The early 1990s was when the term jobless recovery was first coined. The Fed cut rates all the way into 1993--more than two years into the recovery. Federal deficits remained wide--recall Ross Perot's campaign? Growth was mediocre and productivity weak--Krugman called it the age of diminished expectations. It was not until the second half of the 1990s that the economy kicked into a higher gear. The 2001 recession did not have financial sector complications, but the employment recovery took much longer and private sector employment growth through the expansion was one of the worst ever. Capital spending remained depressed through the recovery. In fact, through the past 25 years, barring the Dotcom bubble phase, capex has never been robust.

      

To the extent the last thirty years appear to have delivered stability, it is because the economy has been operating under considerable slack the bulk of the time (see my post). Persistent slack has meant that the Fed has kept interest rates low for a extended periods of time but also that the feedback loops from balance sheets to the economy have been weak. As a result, rising asset prices or easy credit have failed to stoke the real economy commensurately, keeping interest rates low, supporting balance sheets, and fostering the perception of stability. In turn, this validated balance sheet structures and encouraged further risk taking. In other words, interest rates were not low enough for the real economy but too low to rein in financial market exuberance. However, with the passage of time, the feedback loops from balance sheets to economy strengthened--think wealth effects in the 1990s or home equity extraction in the 2000s--diminishing the slack. At that point, the relationship flipped. The interest rate high enough to stabilize the real economy was too high to stabilize collapsing balance sheets.   

    

All this may sound incredibly nihilistic, but it is not. We need to reorient policy toward building a resilient system not chasing the unattainable goal of stability (see my post).