MNI: Covid Revives Phillips Curve-Former Fed, BOE Officials

The long-dormant Phillips Curve between inflation and unemployment may be about to return with a vengeance, with price rises taking off even when joblessness is at or above pre-Covid levels, according to former senior officials at the Bank of England and the Federal Reserve, whose research is now attracting the attention of the BOE’s Monetary Policy Committee.

In the years prior to the pandemic, the failure of inflation to rise as unemployment hit low levels in developed economies led some central bankers to ponder whether the Phillips Curve was dead. But former Bank of England Monetary Policy Committee and MIT professor Kristin Forbes and Joseph Gagnon, a former senior Fed official now at the Peterson Institute for International Economics, have argued in research co-authored with Christopher Collins that it was merely in abeyance.

Inflation tends not respond to changes in slack when this is substantial but can rise steeply in a low-slack environment, such as that now observed in rich countries, Gagnon and Forbes told MNI.

“We believe that the curve is highly non-linear. We were long operating in the flat region, when unemployment is at or above the natural rate and slack is high,” Gagnon said in an interview.

When there is ample slack “unemployment can move around a lot with no effect on inflation and that is where the economy has been pretty much for the past twenty years or so. But then … if slack gets low, unemployment gets low, there could be sharp increases in inflation,” he said.

CATHERINE MANN CITES WORK

BOE Monetary Policy Committee member Catherine Mann cited the work by Forbes, Gagnon and Collins in a speech in January, warning of upside risks to the MPC’s inflation forecast if prices fail to fall back as Covid effects fade.

“We had this big run up in prices and they are going to be sticky on the way down,” Gagnon said, though he holds out hope that some goods prices which rose exceptionally fast, such as in the auto sector, may retreat over the next 12 months or so.

The steep rise in goods prices as demand rotated away from services during the pandemic was not compensated by falls in service prices, with Gagnon noting that prices tend to be sticky on the way down, helping to explain why the Phillips curves flattens during periods of higher slack.

The research by Gagnon and his co-authors, covering 31 advanced economies, stands in contrast to work by Mann’s MPC colleague Silvana Tenreyo, who argued in a 2019 paper that central bank inflation-targeting suppressed the Phillips curve.

“If central banks do their job they are not going to let unemployment deviate too far from the natural rate and therefore inflation is not going to move from the target. But it is not obvious to me that that means that the Phillips curve is flat. What it means is the Phillips curve is hard to measure,” Gagnon said.

LABOUR MARKET SLACK MEASURES OUT OF DATE

A flatter Phillips curve would in theory allow central banks to tolerate lower levels of unemployment with less fear of inflation. But unemployment levels which are compatible with stable inflation may now be markedly higher than in the past, Gagnon said, because Covid has resulted in people being afraid to return to work, becoming pickier about the jobs they choose, or else opting for early retirement or part-time work.

“The pandemic, Covid, has made it essentially impossible to use the traditional labour market slack measures … We believe the natural rate of unemployment has temporarily moved up a lot so that we are on the steep part of the Phillips curve,” Gagnon said.

Earlier work from Forbes highlighted how UK inflation dynamics could largely be explained by a slow-moving trend and were significantly correlated with international prices, with slack playing a lesser role. But that older research did not focus on what happened to inflation with a positive output gap, Forbes said.

The more recent work uses “a more sophisticated measure that not only looks at the unemployment rate or output gap, but hours worked/participation/share of part-time work,” she told MNI, echoing Gagnon’s point that some traditional labour market slack measures have become redundant.