This is not your father’s inflation – and that’s good news. Business cycles often end when higher inflation causes a country’s central bank (the Federal Reserve in the United States) to raise interest rates, slowing the economy and, perhaps, triggering a recession. The good news: The next recession may be delayed, because the Phillips Curve has shifted.
The Phillips Curve is an analytical tool used by economists. It shows the relationship between inflation and unemployment. In general, as unemployment goes down, inflation goes up, because companies compete for scarcer labor by offering higher wages. Wage increases are then passed along to consumers in higher prices. So: Preventing or slowing higher inflation often relies on higher interest rates, even if that risks recession.
(The Phillips Curve is named for New Zealand economist A.W. Phillips, who reported the relationship after studying British economic data from 1861 to 1957.)
By traditional Phillips Curve standards, the economy appears ready for higher interest rates. At 4.3 percent in May, the U.S. unemployment rate is at a 16-year low. Since December 2015, the Fed has raised short-term interest rates four times, though they remain at historically low levels, between 1 percent and 1.25 percent. There has been much speculation about the Fed’s next rate hike. It may be later rather than sooner. Economists from the Bank for International Settlements (BIS) in Basel, Switzerland – a bank for government central banks – find that the pass-through from wage increases to price increases has weakened. If this is confirmed and continues, it implies that inflation will remain tame for some time even if the economy continues to grow.
Just what caused the breakdown of the old Phillips Curve relationship isn’t clear. Nor is it clear whether the shift is permanent. Arguably, it might just reflect an ongoing hangover from the Great Recession. Firms raise prices reluctantly, because they fear losing sales.
In a public presentation, Claudio Borio, head of the BIS’s Monetary and Economic Department, offered another explanation. It’s globalization: the expansion of so-called global value chains – supply chains that manufacture components for a final product in many countries.
Facing higher costs, companies can relocate production to countries with cheap labor or superior production technology, a.k.a. “automation.” In the past quarter-century, there has been a vast expansion of global labor markets, Borio noted. Businesses that are mobile have undermined workers’ bargaining power. Consider. In 1990, advanced economies such as the United States, Japan and Western Europe represented 41 percent of the world labor force; other countries, such as China and India, 59 percent. By 2015, the figures were 18 percent for advanced economies and 82 percent for other countries. If Borio is right, it could explain why annual consumer price inflation has generally been below the Fed’s official target of 2 percent (inflation low enough not to bother people but high enough to prevent deflation – falling prices). More important, a new Phillips Curve, if true, gives the Fed more leeway to meet its twin goals of high employment and low inflation.
Published in Daily Times, July 3rd , 2017.