What is the Phillips Curve?

  The Phillips Curve is a graphic representation of the economic relationship between the rate of unemployment (or the rate of change of unemployment) and the rate of change of money wages. Simply put, the Phillips Curve stands for the proposition that when economic activity booms and unemployment falls below its natural rate, we have inflation. Conversely, when the economy is in recession and employment exceeds the natural rate, inflation falls or is not present. Taken a step further, if unemployment falls below the natural rate, employers will aggressively bid for workers, and wages and prices thus increase. Thus, according to the Phillips Curve, there is always a tradeoff.

The Phillips Curve was originally proposed in 1958 by A.W. Phillips. This theory was widely accepted as it appeared to track historical economic trends. Over the last six years, however, the inflation/unemployment relationship that is the heart of the Phillips Curve appears to have broken down. Since 1993 the unemployment rate has fallen from 6.9% to the current 4.1%. That would put unemployment below its 'natural' rate. Inflation, however, has fallen from 2.7% in 1993 to 1.6% through the end of 1998. As the latest economic numbers this year show, inflation has still not reared its head. Indeed, even members of the Federal Reserve early in the year noted that the favorable economic conditions "could not be explained in terms of normal historical relationships."

The problem we noted was that the Fed seemed to be backtracking on its fledgling belief that the Phillips Curve was just a theory after all, and that the last ten years of historical data refuting it was somehow an aberration. It may be an aberration, but it has been one heck of an aberration with no end in sight. Maybe we are optimists, but we don't sit around wringing our hands worrying about when the numbers will end, but what the numbers hold for the future. When you factor in the increased productivity we are seeing that has been brought about by the surge in technology in the U.S. and the very real prospect of productivity continuing to grow at this rate for years as the U.S continues to develop and integrate technology into every aspect of society, maybe we are not optimists. We don't think so. As the Fed's Beige Book pointed out, the economy is strong, but inflation is very low. It has been for years now. Moreover, the prospects for the future look good. That is why we are worried about the Fed's apparent new focus back on Phillips Curve theory.


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