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Phillips Curve

February 9, 1999

Myths die hard, and in the case of the "Phillips Curve," it has taken 20 years of obvious contrary evidence to convince many economists that there is no fixed inverse relationship between unemployment and price inflation.

(Jeffrey Herbener of Grove City College has argued the relationship never existed, not even at the purely empirical level.) The article below quotes some Mises Institute scholars, and generally
provides an interesting treatment of the subject:

Who's Afraid Of A Red-Hot Economy?

Investor's Business Daily

February 9, 1999

For more than 20 years, the Federal Reserve has seen its No. 1 job as
balancing growth and inflation, a duty enshrined in the 1978 Full Employment
and Balanced Budget Act.

The theory behind this mission is that too much growth brings inflation, but
slashing inflation too much would jack up unemployment. So the Fed's job was
to bring the Goldilocks economy: not too hot, not too cold, just right.

But in his latest testimony before the Senate, Fed Chairman Alan Greenspan
shot down that idea, noting that very low rates of inflation have coexisted
with very low rates of unemployment for some time now.

That made many economists and business leaders breathe a sigh of relief,
since it means the Fed is less likely to tighten monetary policy because of
tight labor markets.

Greenspan may have just admitted what economists have known for some time.

"Alan was a late believer in the idea that inflation isn't sparked by too
much growth, but the last few years have convinced him you can have growth
and low unemployment and still maintain low inflation," said Wayne Angell,
chief economist at Bear, Stearns & Co. and a former Fed governor.

It may have taken a mountain of evidence to convince Greenspan, but the link
between inflation and unemployment has been the subject of fierce debate by
economists for almost 40 years.

It started in 1958, when economist A.W. Phillips published an article
claiming to see a link between unemployment and inflation in Great Britain.
When unemployment fell, inflation tended to rise and vice versa.

Soon, other economists started to find that same relationship in the
economies of other nations. The link came to be called the Phillips curve.

For many, all those studies seemed to confirm that there was a link between
growth and inflation. Soon, economists started to say that the job of a
central bank was to maintain the lowest level of unemployment that doesn't
spark inflation: the so-called non-accelerating inflation rate of
unemployment, or NAIRU.

But some economists weren't convinced. At the University of Chicago, Milton
Friedman argued the Phillips curve was just an illusion.

"He argued that price inflation fooled businesses into thinking the demand
for their product was going up. So they hired more people. That's why there
seemed to be a link," said Richard Vedder, an economist at Ohio University.

Friedman's theory explained a key fact about the inflation-unemployment
relation: Inflation tends to precede drops in unemployment, not follow.

"But Friedman said the Phillips curve couldn't be sustained. At some point,
business leaders would wise up, figure out that the reason the prices they
can charge are getting higher is because of inflation, not an increase in
real demand. When that happened the link between inflation and unemployment
would break," Vedder said.

Friedman was largely dismissed in the economics profession until the 1970s.
That's when stagflation, the presence of both high inflation and high
unemployment, confirmed his ideas. Friedman won the Nobel prize in economics
in 1976 for his work.

"There's no question now that inflation is a monetary phenomenon. It
happens when the central bank lets the money supply grow too fast, and there
are too many dollars chasing too few goods," Angell said.

"Economic growth doesn't cause inflation. If anything it helps reduce it.
When there's more goods out there competing for those dollars, it offsets
growth in the money supply," he added.

But some who agree with Angell's point are worried about the current low

"Even Friedman agreed there is what he called a natural rate of
unemployment. Even in a healthy economy there are some people who will be
unemployed for some reason," said Roger Garrison, an economist at Auburn

"The only way to push unemployment below its natural level is to pump money
into the credit markets, heating up the economy in a way that can't be
sustained without bringing price inflation," Garrison said.

Economists since the late 1980s have typically pegged the natural rate of
unemployment at between 5% and 6%.

The U.S. unemployment rate has been below 5% for 18 months. And since the
money supply has been growing for more than two years at above the 3% to 4%
recommended by Friedman, some economists think the Fed has pushed
unemployment below its natural rate. They keep waiting for price inflation
to pick up.

But there's little sign of inflation.

So what gives?

"Since the global economic crisis began, the U.S. has been getting a lot of
cheap imports, especially commodities. That has helped keep prices down,"
said Ram Bhagavatula, chief economist at NatWest Global Financial Markets.
"But once the rest of the world starts recovering, and import prices pick
up, then U.S. inflation could start to grow, and the Fed will have to

A less-troubling theory is that economists are just wrong about where the
natural rate of unemployment is.

"It could be lower now than economists have believed. If so, unemployment
could fall to 4% or 3% or even 2% without any inflation," said Andrew
Hodge, chief U.S. macroeconomist at the Wefa Group, a consulting firm in
Eddystone, Pa.

Welfare reform, rising real wages or other changes may have made joblessness
less attractive and pushed down the natural rate of unemployment. But no one
knows for sure.

"All economists can say right now is that the link between unemployment and
inflation seems to have broken down. But whether this is a temporary
situation or permanent we can't yet say," said Stephen Slifer, chief U.S.
economist at Lehman Bros.

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