This week, the Office for National Statistic (ONS) released their latest set of labour market and inflation data. Both sets of data provide a positive read for the UK. Unemployment is unchanged at 3.8%, for the third consecutive month, wages are higher, increasing from 3.2% to 3.4% whilst inflation remains subdued at 2.0%. The difference, or gap, between wage growth and inflation is positive in real terms. After adjusting for inflation, workers now have more disposable income.
Despite the good news, economists need a theory which proves that all good things come to an end. For this to be realised they rely on the Philips Curve. This theory states that competition for labour increases as unemployment falls. Therefore, wages must rise hitting company profit margins in the process. To compensate, businesses respond by increasing prices for goods and services pushing general prices higher, ergo we have inflation. All very simple except, annoyingly for theorists, the outcome we have today isn’t consistent with theory. Unemployment is at its lowest level since 1974 with inflation restrained and seldom reaching the Bank of England’s 2% target rate.
The reliability of the Phillips Curve as a tool for forecasting inflation is now in doubt. Over time the so-called natural rate of unemployment, somewhere between 4.0% and 5.0% for developed economies, was thought to be the point at which inflation kicked in. However, unemployment is well below the bottom end of the range in both the UK and US without any meaningful effect on inflation, illustrated below.
Economic Conditions in the UK
Source: Bloomberg, July 2019
Economic Conditions in the US
Source: Bloomberg, July 2019
Market commentators and economists have highlighted several factors why the relationship is breaking down: globalisation, technological advances, large government debt levels and the demographics of ageing populations have all been cited as reasons for this phenomenon.
The real answer is most likely a combination of each of the above. It is also worth recalling that in previous business cycles commodity prices, particularly oil, played a significant role in disrupting the Phillips Curve. Supply blockages pushed up price levels without unemployment falling. Thankfully any such bottlenecks have been absent during the current business cycle: the introduction of shale oil supplies from the US counteracting OPEC’s traditional stranglehold on the international oil markets.
Despite its shortcomings the Phillips curve is still out there. Federal Reserve (Fed) chairman, Jay Powell, who was questioned about the curve said there was ‘a faint heartbeat’ of inflationary pressure coming out of the labour market. He confirmed that the current inflationary pressure from labour markets was below “sustainable” levels i.e. he expects wages to push higher if the labour market tightens further.
Flexibility in the jobs market has thus far allowed central banks to loosen monetary policy without witnessing the higher inflation that often follows such a move. However, by downgrading theory previously guiding monetary policy it leaves central bankers open to accusations that they are acting in a politically motivated way. To fight these accusations, they need to articulate why it is safe, possibly temporarily, to ignore this theory.
For example, changes in technology are having a profound impact on jobs. The current narrative is that robots will take over. However, it is interesting to note that Amazon is spending $700m retraining a third of their workforce to cope with changes in work practices rather than sacking them.
Understanding shifting trends at the micro level represents a great challenge for central bankers, but they must try even harder to understand and explain the countervailing forces at large. The Phillips Curve may re-establish itself at some point but until it does central banks risk being accused of bowing to political pressures. By proposing lower interest rates at a time of low unemployment, the US Fed is having its independence questioned. However, given the forces at large pushing against the Phillips Curve it seems more likely they are acting in a pragmatic way. Thus, those questioning the Fed’s policy shift to being more dovish may be pursuing their own political agendas. The theory is still alive, but for now it is resting.< Back to Blog