The Phillips curve, introduced in the 1950s, is an economic concept that illustrates a stable, inverse relationship between inflation and unemployment.

The 1970s, which were characterized by stagflation, or slow economic growth and relatively high unemployment, brought the validity of the Phillips curve into question. This stagflationary episode highlighted the need to supplement the Phillips curve framework to ­incorporate inflation expectations, which had become unanchored during the 1970s.

So, the concept of the natural unemployment rate, or the non-accelerating rate of unemployment (NAIRU or U*) was introduced to Phillips curve analysis. This is the unemployment rate at which, in the long run, accounting for stable expectations, no matter the inflation rate, unemployment would remain constant — with no tradeoff between inflation and growth. This concept is represented as the vertical line, the long run Phillips curve (LRPC) in the hypothetical example in Chart 1.

Chart 1: What is the Phillips curve?
Source: aRI, April 2022. For illustrative purposes only.

In the short run, as medium-term inflation expectations remain stable, the Phillips curve would be downward sloping. This is illustrated by the short run Phillips curve (SRPC 1) in Chart 1.

But if policymakers ignore expectations and attempt to overstimulate the economy so that the unemployment rate falls much lower than U*, inflation expectations can increase significantly. The short run Phillips curve then shifts higher along the vertical line, which we’ve illustrated with the SRPC 2 line in Chart 1.

In the scenario represented by SRPC 2, inflation will be higher for each given rate of unemployment. For instance, moving from point A to point B, unemployment remains the same, but, in this example, the inflation rate has more than doubled (from 2% to 6%). This is similar to the shift that happened in the 1970s, thanks to a combination of central bank policy errors and oil shocks, which, together, caused inflation expectations to become unanchored.

Alternately, the Phillips curve can steepen or the economy could adjust and settle at a steeper part of the curve. In Chart 1, this could be represented as a move from point A to point C, with lower unemployment but higher inflation.

From observing point C, it’s not possible to tell whether the Phillips curve has shifted. However, the implications of being on SRPC 1 or SRPC 2 are huge for monetary policy and the economic outlook.

We can use our this hypothetical example to examine the “sacrifice ratio,” or how much growth or employment may be lost in the process of taming inflation. Chart 2 illustrates the current environment. Assume that at Point C, inflation has accelerated to 8% during the course of the pandemic, compared to an average of 2% before the pandemic. Assume that following the initial spike in unemployment during lockdowns, the combination of fiscal and monetary policy have pushed unemployment well below U* to U1%.

Chart 2: What might the Phillips curve tell us now?

Source: aRI, April 2022. For illustrative purposes only.

If point C is on the steeper portion of the SRPC 1, policymakers only have to tighten policy enough to bring the economy back to point A. The “sacrifice” to return to 2% inflation levels is an increase in unemployment, as represented by a move from U1% back to U* in Chart 2, so the steepness of the curve at this point offsets the magnitude of the adjustment.

However, if the Phillips curve has shifted up to SRPC 2, then the central banker’s task becomes harder. A recession would likely be triggered in this scenario as policymakers hike much more aggressively to tame inflation. Bringing inflation back down to 2% in this scenario would require many more jobs to be lost, as the gap between U1% and U2% in Chart 2 suggests.


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