Phillips Curve Makes Ugly Comeback

The WSJ is claiming that the Phillips curve is making an ugly come back. I do not think that this is the case. Those in the 1990s who did not shelve the Phillips curve did so, becuase they drew a distintion between a static Phillips curve and a Phillips curve that is shifting; That was the issue not that there was no Phillips curve.
Here is the comeback story from the WSJ.
The recent comeback of the economic theory known as the Phillips Curve is a little like Mickey Rourke’s latest comeback on the Hollywood red carpet: it’s kind of scary to watch it play out.
The central idea of the theory named for economist Alban William Phillips is that there’s an inverse relationship between unemployment and inflation. It was shelved by some in the 1990s when unemployment fell to historically low levels without the expected uptick in inflation.
But the relationship appears to have reinserted itself, something households are being reminded of in painful ways via job and salary cutbacks almost daily.
The national unemployment rate already increased over two percentage points in the final eight months of 2008 to 7.2%, and that’s before the recent flood of corporate layoffs. Meanwhile, inflation has fallen off sharply.
In a one-day bloodbath for the economy, companies from across the economic spectrum, including Caterpillar Inc., Sprint Nextel Corp., Pfizer Inc., Home Depot Inc. and General Motors Corp., all announced layoffs on Monday alone.
And as the Phillips Curve would predict, the effects are being felt not just by the unemployed but the employed, too. Companies from Home Depot to Yahoo Inc. and Eddie Bauer Holdings Inc. have recently launched salary freezes for at least some of their staffs. Even the Obama Administration has instituted pay freezes for top White House positions.
Predictably, households fearful of job or at least income cuts are reporting record-low levels of confidence, according to the latest Conference Board survey released Tuesday. And inflation has come down drastically even when energy prices are excluded, reflecting the reluctance of consumers to spend.
“The Phillips Curve was out of vogue for a while, but now it’s back,” said Sung Won Sohn, a professor at California State University.
The point is more than just academic.
As Laurence Meyer and Brian Sack of Macroeconomic Advisers point out, there are two ways of looking at the inflation outlook now. Those who think monetary aggregates such as bank reserves are a determinant would likely see greater risk that inflation will bubble up again once the economy stabilizes.
Yet those economists that generally base their forecasts on a Phillips Curve framework, including Meyer and Sack, think outright deflation is the greater risk. “Exit from extraordinary policy actions is a very long way off from this perspective,” they said in a research note.
“The current episode looks almost like a laboratory experiment to test the validity of the Phillips curve and, particularly, the relative usefulness of the Phillips curve and the monetary aggregates in forecasting near-term inflation,” said Meyer, a former Fed governor, and Sack, a former Fed economist.
That economists are even reexamining the validity of the Phillips Curve is surprising. After the mid-1990s the theory appeared woefully outdated as the unemployment rate fell below levels long thought to be inflationary. Indeed even rates as low as 4% didn’t appear to be driving price pressures higher.
Explanations abounded: productivity had changed the relationship between joblessness and wages; global competition meant the U.S. unemployment rate was too narrow of a focus; better management of monetary policy since the 1980s had already licked inflation; and, more recently, energy and commodity prices were key drivers of inflation.
But with the unemployment-wage link apparently reestablished, “it’s possible that for the next couple of years we could see the Phillips Curve operate as it’s supposed to,” said Sohn.
Of course, the question remains exactly what rate of unemployment is consistent with stable inflation, otherwise known as the non-accelerating inflation rate of unemployment or Nairu. Long thought to have been around 6% until the late 1990s, it’s surely lower than that now, but whether it’s 4% or 5% could have a big effect on just how quickly inflation comes down, especially now that energy prices have stabilized.
Another question is whether the Phillips Curve flattens when inflation hits zero — in other words, can the unemployment rate keep rising without leading to outright deflation.
Unfortunately for many U.S. households, they’ll see that debate play out in the newspaper every day. –Brian Blackstone